Publication
Tax Guide for 334 95
Cat. No. 11063P
Department
of the
Treasury
Small Business For use in
preparing
For Businesses
Internal
Revenue 1995
Service Returns
Tax Guide for
Small Business
Department
of the
Treasury Contents
Internal
Revenue
Service
Introduction ............................................................. 1 22 Gains and Losses: Capital or Ordinary ....... 105
23 Dispositions of Depreciable Property.......... 112
Important Changes for 1995 ................................. 1 24 Installment Sales .......................................... 118
25 Casualties, Thefts, and
Important Reminders ............................................. 2 Condemnations ............................................. 123
26 Reporting Gains and Losses ....................... 131
Part I The Business Organization ......................... 5
1 Initial Considerations .................................... 5
Part VI The Business Activity................................ 133
2 Books and Records ...................................... 8
27 Sole Proprietorships..................................... 133
3 Accounting Periods and Methods ............... 10
28 Partnerships.................................................. 135
29 Corporations ................................................. 140
Part II Business Assets........................................... 14
30 S Corporations.............................................. 145
4 Capital Expenses .......................................... 14
5 Basis of Assets ............................................. 18
Part VII Credits, Other Taxes, and Information
Part III Figuring Gross Profit ................................. 24 Returns ............................................................... 150
6 Business Income .......................................... 24 31 General Business Credit .............................. 150
7 Cost of Goods Sold....................................... 30 32 Self-Employment Tax................................... 155
8 Gross Profit ................................................... 34 33 Employment Taxes....................................... 160
34 Alternative Minimum Tax ............................. 171
Part IV Figuring Net Income or Loss.................... 35 35 Excise Taxes................................................. 178
9 Employees’ Pay ............................................ 35 36 InformationReturns...................................... 180
10 Retirement Plans .......................................... 39
11 Rent Expense ............................................... 45 Part VIII Filled-In Forms.......................................... 184
12 Depreciation.................................................. 48 37 Schedule C—Sole Proprietorship ............... 184
13 Amortization and Depletion ......................... 59 38 Form 1065—Partnership ............................. 191
14 Bad Debts ..................................................... 65 39 Form 1120–A—Corporation
15 Travel, Entertainment, and Gift (Short-Form) .................................................. 199
Expenses ....................................................... 68 40 Form 1120—Corporation............................. 202
16 InterestExpense........................................... 81 41 Form 1120S—S Corporation ....................... 209
17 Insurance ...................................................... 85
18 Taxes............................................................. 87
The Examination and Appeals Process .............. 218
19 Other Business Expenses............................ 89
20 Net Income or Loss ...................................... 94
Index .......................................................................... 220
Part V Disposing of Business Assets................... 100
21 Sales and Exchanges................................... 100 Tax Publications ...................................................... 224
All material in this The explanations and examples in this publication re- these differing interpretations are resolved by higher
publication may be flect the interpretation by the Internal Revenue Service court decisions or in some other way, this publication
reprinted freely. A (IRS) of: will continue to present the interpretation of the
citation to Tax Guide for Service.
Small Business (Rev. ● Tax laws enacted by Congress, All taxpayers have appeal rights within the Service
Nov. 95) would be and may appeal to the courts when they do not agree
appropriate.
● Treasury regulations, and
with the interpretations taken by the Service. For a dis-
● Court decisions. cussion on appeal procedures, see The Examination
and Appeals Process in this publication.
However, the information given does not cover every
situation and is not intended to replace the law or
change its meaning.
The publication covers some subjects on which a
court may have made a decision more favorable to tax-
payers than the interpretation of the Service. Until
Introduction
This publication contains infor- specific tax considerations for information publications. If you publications that are for sale call
mation about the federal tax laws each of the four major forms of operate a farm or a fishing busi- 1–202–512–1800 or write to:
that apply to businesses. It de- business organization. ness, you should obtain a copy of
scribes the four major forms of Part VII looks at some of the Farmer’s Tax Guide (Publication Superintendent of
business organization—sole pro- credits that can reduce your in- 225) or Tax Guide for Commer- Documents
prietorship, partnership, corpora- come tax, and some of the other cial Fisherman (Publication 595). U.S. Government Printing
tion, and S corporation—and ex- taxes you may have to pay in ad- For information on the individ- Office
plains the tax responsibilities of dition to income tax. It also dis- ual income tax, you may want to P.O. Box 371954
each. cusses the information returns see the companion volume to Pittsburgh, PA. 15250-7954
The Tax Guide for Small Busi- that may have to be filed. The last this publication, Your Federal In-
ness is divided into eight parts. part, Part VIII, shows how to fill come Tax (Publication 17). If you want information from
The first part contains general in- out the main income tax forms In addition to these publica- the Small Business Administra-
formation on business organiza- businesses use. tion (SBA) on setting up a small
tions, the Internal Revenue Ser-
tion and accounting practices. The information in this publi- business, call 1–800–827–5722.
vice has many other tax publica-
Part II discusses the tax aspects cation applies to many different We welcome your sugges-
tions that may be of interest to
of accounting for the assets used kinds of businesses. However, tions for future editions of this
you. Most of them are concerned
in a business. the publication does not discuss publication. Please send your
with particular areas of tax law,
Parts III and IV explain how to foreign corporations, insurance ideas to:
such as depreciation, selling a
figure your business income for companies, collapsible corpora-
tax purposes. They describe the tions, personal holding compa- home, rental property, retirement
income, or installment sales. You Internal Revenue Service
kinds of income you must report nies, banks, regulated invest- Technical Publications
and the different types of busi- ment companies, small business will find references to many of
these publications throughout Branch (T:FP:P)
ness deductions you can take. investment companies, real es- 1111 Constitution Ave. N.W.
Part V discusses the rules tate investment trusts, foreign this publication. They are all
available free from the Forms Washington, DC 20224
that apply when you sell or ex- sales corporations (FSCs), and
change business assets or in- integrated oil companies. It also Distribution Center for your area.
vestment property. It includes does not discuss bankruptcy or Use the order blank at the end of We respond to many letters
chapters on the treatment of cap- corporate reorganizations and this publication. by telephone. Therefore, it would
ital gains and losses, and on in- acquisitions. Other federal agencies also be helpful if you include your area
voluntary conversions, such as The special situations related publish publications and pam- code and daytime phone number
theft and casualty losses. The to farming and commercial fish- phlets designed to assist small along with your return address. ð
chapters in Part VI contain some ing are covered in two other tax businesses. For a list of federal
Important Changes for 1995
The following items highlight a miles on a passenger automobile $4,900 for the second year of re- make tax deposits without cou-
number of administrative and tax (including vans, pickups, or covery, $2,950 for the third year pons, paper checks, or visits to
law changes for 1995. panel trucks). See chapter 15. of recovery, and $1,775 for each an authorized depositary.
later tax year. See chapters 12 Taxpayers not required to
Caution: As this publication was Receipts for business ex- and 15. make deposits by EFT can enroll
being prepared for print, Con- penses. Beginning October 1, in the system. For more informa-
gress was considering tax law 1995, you must have receipts for tion, call 1–800–829–5469, or
changes that would affect capital amounts that are $75 (rather Direct deposit of refund. If you write to:
gains and losses. See Publica- than $25) or more for certain are due a refund on your 1995
tion 553, Highlights of 1995 Tax business expenses. See chapter tax return, you can have it depos- IRS
Changes, for further 15. ited directly into your bank ac- Cash Management Site
developments. count. Complete Form 8888, Di- Office
Depreciation general asset ac- rect Deposit of Refund, and Atlanta Service Center
Higher earned income credit. count. You can elect to place attach it to your tax return (ex- P.O. Box 47669
The maximum earned income assets subject to MACRS in one cept Form 1040EZ). If you did Stop 295
credit has been increased to or more general asset accounts. not receive Form 8888 in your Doraville, GA 30362
$3,110 in 1995. To claim the After you have established a tax booklet, see Ordering publi-
credit for 1995, you must have general asset account, figure de- cations and forms, later.
earned income (including net preciation on the entire account Tax rates and maximum net
earnings from self-employment) by using the applicable deprecia- earnings for self-employment
Electronic deposit of taxes. In
of less than $26,673, adjusted tion method, recovery period, taxes. In 1995, the maximum
general, taxpayers whose total
gross income of less than and convention for the assets in amount of net earnings from self-
$26,673, and meet certain other the account. See chapter 12. deposits of railroad retirement, employment subject to the social
requirements. social security, and Medicare security part (12.4%) of the self-
For more information, see Limits on depreciation of busi- taxes exceeded $47 million dur- employment tax is $61,200.
Publication 596, Earned Income ness cars. The total section 179 ing calendar year 1993 or 1994 There is no maximum limit on the
Credit. deduction and depreciation you must deposit these taxes amount subject to the Medicare
can take on a car that you use in through TAXLINK (an electronic part (2.9%).
Standard mileage rate. The your business and first place in funds transfer (EFT) system) be- For 1996, the maximum
standard mileage rate for 1995 is service in 1995 is $3,060. Your ginning in 1996. The EFT system amount subject to the social se-
30 cents a mile for all business depreciation cannot exceed (TAXLINK) allows taxpayers to curity part (12.4%) increases to
Page 1
$62,700. All net earnings from Also, the deduction is in- Distribution of marketable se- if IRS information is available
self-employment are subject to creased to 30% for tax years be- curities to a partner. A distribu- and if so, how to access it.
the Medicare part of the tax. See ginning after 1994. See chapter tion of certain marketable securi- Tax forms and publications
chapter 32. 17. ties made to a partner after are also provided through IRIS
December 8, 1994, is treated as on FedWorld (a government bul-
Wage maximums for social se- Educational assistance pro- money in determining whether letin board).
curity and Medicare taxes. For grams. The income exclusion gain is recognized by the partner Also, you can purchase a
1996, the maximum amount of provision for employer-provided on the distribution. See Distribu- comprehensive CD-ROM con-
wages subject to the social se- educational assistance does not tions From a Partnership in Publi- taining all the latest tax forms, in-
curity tax (6.2%) is $62,700 apply to tax years beginning after cation 541. structions, and information
($61,200 for 1995). There is no December 31, 1994. publications.
wage base limit for the amount Caution:As this publication Office of Small Business Af- For more information, see
subject to the Medicare part was being prepared for print, fairs. In March 1994, the Com- How To Get Forms and Publica-
(1.45%). All covered wages are Congress was considering tax missioner of the Internal Reve- tions, near the end of this
subject to the tax. law changes that would extend nue Service established the IRS publication.
the income exclusion for em- Office of Small Business Affairs.
Health insurance for self-em- ployer-provided educational This office was established to
ployed persons. The deduc- assistance. serve as the national IRS con- General business credit. The
tion for health insurance costs tact with small businesses, to following general business cred-
See Publication 553, High-
for self-employed persons has recommend changes to regula- its have expired.
lights of 1995 Tax Changes, for
been permanently extended for tions and administrative prac- Targeted jobs credit. This
further developments.
tax years beginning after 1993. If tices that cause undue burden or credit cannot be claimed on any
you were entitled to claim this inequity, and to address issues
Fuel taxes. Some tax rates and wages paid or incurred to individ-
deduction in 1994 but did not, file that are important to both small
the credit or refund amount you uals who begin work after De-
Form 1040X, Amended U.S. In- businesses and the IRS.
may receive have changed. Get cember 31, 1994.
dividual Income Tax Return to
the appropriate form for the cur- Research credit. This credit
amend your 1994 tax return. Do On-line access to the Internal
rent rate. cannot be claimed for any
not use the worksheet in the Revenue Service. If you have a
amount paid or incurred after
1995 Form 1040 instructions to personal computer and a
figure your deduction for 1994. Luxury tax on passenger vehi- modem, you can get many tax June 30, 1995.
Instead, get Publication 535, cles. The base amount used to forms and publications electroni- For more information on the
Business Expenses, or use the figure the taxable part of a pas- cally. If you subscribe to an on- general business credit, see
worksheet in the 1994 Form senger vehicle’s first retail sale line service, check with the pro- chapter 31. ð
1040 instructions. or use is $34,000 for 1996. vider of the service to determine
Important Reminders
Publication on employer iden- If you have a balance due on stock, see chapter 4 of Publica- and can deduct the expenses on
tification numbers (EINs). Pub- your Form 1040, send the tion 550, Investment Income and Schedule C (Form 1040), you
lication 1635, Understanding voucher with your payment. Fol- Expenses. must figure your deduction on
Your EIN, provides general infor- low the instructions that come Form 8829, Expenses for Busi-
mation on employer identifica- with the voucher. There is no Earned income credit. You, as ness Use of Home, and attach it
tion numbers. Topics include penalty for not using the pay- an employer, must notify em- to Form 1040 with Schedule C.
how to apply for an EIN and how ment voucher, but the IRS ployees who worked for you and For more information, see Publi-
to complete Form SS–4. strongly encourages you to use from whom you did not withhold cation 587, Business Use of
it. income tax about the earned in- Your Home.
Form W–4 for 1996 You should come credit. See chapter 33.
make new Forms W–4 available Change of home or business
to your employees and en- Payment voucher for Form Children employed by par- address. If you change your
courage them to check their in- 940 or 940–EZ. If you are re- ents. Wages you pay to your mailing address, you should use
come tax withholding for 1996 quired to make a payment of fed- children age 18 and older for ser- Form 8822, Change of Address,
Those employees who owed a eral unemployment tax with vices in your trade or business to notify IRS. Be sure to include
large amount of tax or received a Form 940 of Form 940–EZ, use are subject to social security your suite, room, or other unit
large refund for 1995 may need the payment voucher at the bot- taxes. See chapter 33. number. Send the form to the In-
to file a new Form W–4. See tom of the form. For more infor- ternal Revenue Service Center
chapter 33. mation, see the instructions for Employees’ tips. All tips re- for your old address.
Form 940 or Form 940–EZ. ported by an employee are sub-
Payment voucher for Form ject to the employer portion of Estimated tax. If you do busi-
1040. To help process tax pay- the social security tax. Thus, you ness as a sole proprietor, or you
ments more accurately and effi- Investing in small business must pay the employer social se- are a partner in a partnership, or
ciently, the IRS is sending Form stock. Beginning in 1998, invest- curity tax on the total amount of a shareholder in an S corpora-
1040–V, Payment Voucher, to ments in certain small business tips and wages up to the social tion, you may have to make esti-
most 1040 filers. Over the next stock held more than 5 years will security maximum. See chapter mated tax payments. Use Form
few years, IRS will expand the qualify for a special tax benefit. If 33. 1040–ES, Estimated Tax for Indi-
use of this preprinted payment you sell or exchange the stock at viduals. Also, use the Checklist
voucher to all 1040 filers to pro- a gain, only one-half of the gain Business use of your home. If near the end of this publication
cess payments more accurately will be subject to federal income you used part of your home in to determine the due dates for
and efficiently. tax. For information on qualifying 1995 for your trade or business making the payments.
Page 2
Corporations that have to course of your business, you 3) Fraud and false statements, Internal Revenue Service Cen-
make estimated tax payments must file information returns to and ters, as well as questions on the
may use Form 1120–W (Work- report these payments for the status of tax refunds. The publi-
4) Preparing and filing a fraud-
sheet), Corporation Estimated year. See chapter 36. cation also lists free taxpayer in-
ulent return.
Tax, or Form 1120–(FY), Fiscal formation publications. It gives
Year Corporation Estimated Tax. Penalties. There are various brief descriptions of their content
A corporation may also use the penalties you should be aware of and a list of related tax forms and
Reminders—Before you file
Checklist near the end of this when preparing your return. You schedules discussed in the publi-
your tax return, be sure to:
publication to determine its due may be subject to penalties if cation. For information about
dates for making the payments. you: Use address label. Transfer
getting Publication 910, see Or-
See chapter 29. the address label from the tax re-
1) Do not file your return by the dering publications and forms,
turn package you received in the
due date. This penalty is 5% next.
mail to your tax return, and make
Corporate estimated tax rules. for each month or part of a any necessary corrections.
A corporation’s estimated tax month that your return is Ordering publications and
payments must be based on the Claim payments made. Be
late, up to 25%. forms. To order free publica-
lesser of: sure to include on the appropri-
2) Do not pay your tax on time. tions and forms, call 1–800–
ate lines of your tax return any
1) 100% of the tax shown on This penalty is 1/ 2 of 1% of TAX–FORM(1–800–829–3676).
estimated tax payments and fed-
the corporation’s return for your unpaid taxes for each You can also write to the IRS
eral tax deposit payments you
the preceding tax year, or month or part of a month af- Forms Distribution Center near-
made during the tax year. Also,
ter the date the tax is due, est you. Check your income tax
2) 100% of the tax for the cur- you must file a return to claim a
up to 25%. package for the address.
rent year (the current year refund of any payments you
made, even if no tax is due. If you have a personal com-
tax may be determined on 3) Substantially understate
Attach all forms. Attach all puter and a modem, you can also
the basis of actual income your tax. This penalty is get many forms and publications
or annualized income). 20% of the underpayment forms and schedules in se-
electronically. See How To Get
that is due to the quence number order. The se-
quence number is just below the Forms and Publications near the
See chapter 29. understatement.
end of this publication.
year in the upper right corner of
4) File a frivolous tax return.
Corporate estimated tax pen- the schedule or form. Attach all
This penalty is $500. Telephone help. You can call
alty. Generally, a penalty ap- other statements or attachments
5) Fail to supply your social se- last, but in the same order as the the IRS with your tax question
plies to the underpayment of an
curity number. This penalty forms or schedules they relate Monday through Friday during
installment of estimated tax. The
is $50 for each failure. to. Do not attach these other regular business hours. Check
underpayment of any installment
is the required payment minus statements to the related form or your income tax package or tele-
the amount paid by the due date. Tax shelter penalties. Tax schedule. phone book for the local number
See chapter 29. shelters, their organizers, their Fill out self-employment or you can call 1–800–829–1040.
sellers, or their investors may be tax return. Fill out Schedule SE
subject to penalties for such ac- (Form 1040) if you had net earn- Telephone help for hearing-
Amortization of goodwill and
tions as: ings from self-employment of impaired persons. If you have
certain other intangibles. You
may have to amortize goodwill 1) Failure to furnish tax shelter $400 or more. access to TDD equipment, you
and certain other intangible registration number. The Use correct lines. Enter in- can call 1–800–829–4059 with
property over a period of 15 penalty for the seller of the come, deductions, credits, and your tax question or to order
years. See chapter 13. tax shelter is $100; the pen- tax items on the correct lines. forms and publications. See your
This amortizable property is alty for the investor in the Sign and date return. Make tax package for the hours of
called section 197 property and, tax shelter is $250. sure the tax return is signed and operation.
if held for more than one year, it 2) Failure to register a tax shel- dated.
may qualify for capital gain treat- ter. The penalty for the orga- Submit payment. For Forms Written tax questions. You can
ment on its sale or other disposi- nizer of the tax shelter is the 1040 and 1120S filers, enclose a send written tax questions to
tion. See chapter 22. greater of 1% of the amount check for any tax you owe. If the your IRS District Director. If you
invested in the tax shelter or check accompanies your Form do not have the address, you can
Deductions for clean-fuel ve- $500. 1040, write your social security get it by calling 1–800–829–
hicles and certain refueling number on the check. If the 1040. The IRS is working to de-
3) Not keeping lists of inves- crease the time it takes to re-
property. Deductions are al- check accompanies Form
tors in potentially abusive spond to your correspondence.
lowed for clean-fuel vehicles and 1120S, write your employer iden-
tax shelters. The penalty for If you write, the IRS can usually
certain clean-fuel vehicle refuel- tification number, the tax period,
the tax shelter is $50 for reply within about 30 days.
ing property placed in service af- and the tax form number on the
each person required to be
ter June 30, 1993. For more in- check. Also include the tele-
on the list, up to a maximum
formation, see chapter 15 in phone number and area code Tele-Tax. The IRS has a tele-
of $100,000.
Publication 535. where you can be reached dur- phone service called Tele-Tax.
ing the day. For 1120 filers, de- This service provides recorded
Fraud penalty. The penalty
Credit for qualified electric ve- posit your tax payment with Form tax information on approximately
for underpayment of taxes due to
hicles. A tax credit is available 8109, Federal Tax Deposit 140 topics covering such areas
fraud is 75% of the part of the
for qualified electric vehicles Coupon. as filing requirements, employ-
underpayment due to fraud.
placed in service after June 30, ment taxes, taxpayer identifica-
Criminal penalties. You may
1993. For more information, see Free tax help. Publication 910, tion numbers, and tax credits.
be subject to criminal prosecu-
chapter 15 in Publication 535. Guide to Free Tax Services, pro- Recorded tax information is
tion (brought to trial) for actions
vides information on where to available 24 hours a day, 7 days
such as:
Form 1099–MISC. If you make get help in preparing tax returns. a week, to taxpayers using push-
total payments of $600 or more 1) Tax evasion, It describes the kind of year- button telephones, and during
during the year to another per- 2) Willful failure to file a return, round services available in regular working hours to those
son, other than an employee or supply information, or pay resolving questions on bills, let- using dial telephones. The topics
generally a corporation, in the any tax due, ters, and notices received from covered and telephone numbers
Page 3
for your area are listed in the corrected. See Publication 594, cents to the next dollar. For ex- you owe tax, you can file early
Form 1040 instructions. Understanding the Collection ample, $1.49 becomes $1 and and pay by April 15, 1996.
Process, for more information. $2.50 becomes $3. In many states, you can elec-
Unresolved tax problems. IRS If you do round off, do so for tronically file your state tax return
has a Problem Resolution Pro- Small business workshops. all amounts. However, if you with your federal return. Check
gram for taxpayers who have Workshops are offered for self- have to add two or more with your tax return preparer or
been unable to resolve their employed or small business amounts to figure the total to transmitter. Also, many compa-
problems with the IRS. If you owners who want to learn about enter on a line, include cents nies offer electronic filing as a
have a tax problem you have the tax aspects of running their when adding the amounts and benefit for their employees.
been unable to resolve through businesses. For details, call IRS only round off the total. Check with your employer.
normal channels, write to your lo- at the number listed in your tele- TeleFile. Single taxpayers
cal IRS District Director or call phone directory under U.S. Gov- who filed a 1994 Form 1040EZ
Alternative ways of filing. IRS
your local IRS office and ask for ernment and ask for the Tax- may receive a TeleFile tax pack-
offers several alternatives to
Problem Resolution assistance. payer Education Coordinator. age that will allow them to file
make filing your tax return easier.
Although the Problem Reso- their 1995 tax return by phone.
They are more convenient and
lution Office cannot change the TeleFile is fast, easy, and free. It
Business codes. You must accurate and will help us pro-
tax law or technical decisions, it is available 24 hours a day and
enter on the appropriate line of cess your return faster.
can frequently clear up misun- there is nothing to mail. IRS auto-
derstandings that resulted from your return a code that identifies Electronic filing. You can matically sends the TeleFile
previous contacts. For more in- your principal business or pro- file your return electronically package to persons eligible to
formation, get Publication 1546, fessional activity. It is important whether you prepare your own use this method of filing, includ-
How to Use the Problem Resolu- to use the correct business return or use a tax preparer. ing students.
tion Program of the IRS. code, since this information will However, you must use an IRS- Other alternatives. If you
Hearing-impaired taxpayers identify market segments of the approved tax preparer or com- have a computer, tax software,
who have access to TDD equip- public for IRS Taxpayer Educa- pany to file an electronic return. and a modem, you can file an
ment may call 1–800–829–4059 tion programs. This information If you file a complete and ac- electronic return with certain on-
to ask for help from Problem is also used by the U.S. Census curate electronic return, your re- line services. Check with your
Resolution. Bureau for its economic census. fund will be issued within 21 on-line service.
See the sample returns in Part days. (Some refunds may be More information. Call Tele-
Overdue tax bill. If you receive VIII. delayed as a result of compli- Tax and listen to topic 252 for
a bill for overdue taxes, do not ig- ance reviews to ensure the accu- more information. Check your
nore the tax bill. If you owe the Rounding off dollars. You may racy of the returns.) You can also tax package for information
tax shown on the bill, you should round off cents to the nearest choose the convenience and about Tele-Tax. ð
make arrangements to pay it. If whole dollar on your return and safety of direct deposit. IRS noti-
you believe it is incorrect, con- schedules. To do so, drop fies your electronic return trans-
tact the IRS immediately to sus- amounts under 50 cents and in- mitter that your return has been
pend action until the mistake is crease amounts from 50 to 99 received and accepted. Also, if
Page 4
Part One.
The Business This Part discusses some of the things you must consider when setting up a
business. The first chapter briefly describes the major forms of business
organization and discusses how each is taxed. The other chapters discuss
Organization recordkeeping, accounting periods, and accounting methods.
□ SS–5 Application for a Social figures gain or loss separately on each as-
Security Card set. See chapter 27 for information on the
1. □ W–9 Request for Taxpayer sale of your sole proprietorship.
Identification Number and Certification Rules. Other rules explained in this pub-
Initial □ 1040 U.S. Individual Income Tax
lication apply to sole proprietorships unless
stated otherwise.
Return
Considerations □ Sch C (Form 1040) Profit or Loss
From Business
□ Sch C–EZ Net Profit From Business
Partnerships
A partnership is not a taxable entity. How-
Introduction □ 1065 U.S. Partnership Return of
Income ever, it must figure its profit or loss and file a
Once you have decided to start a business, return. A partnership files its return on Form
□ 1120 U.S. Corporation Income Tax 1065.
you must decide what type of business entity
Return A partnership is the relationship existing
to use. Your decision will depend on tax and
legal considerations. The tax element is dis- □ 1120–A U.S. Corporation Short-Form between two or more persons who join to-
cussed in this chapter. However, legal con- Income Tax Return gether to carry on a trade or business. Each
siderations are beyond the scope of this person contributes money, property, labor,
□ 1120S U.S. Income Tax Return for an
publication. Normally, a business is con- or skill, and expects to share in the profits
S Corporation
ducted in the form of either a sole proprietor- and losses of the business.
ship, partnership, or corporation. For income tax purposes, the term ‘‘part-
In the case of a sole proprietorship or a nership’’ includes a syndicate, group, pool,
partnership, the business itself does not pay
any income taxes. The sole proprietor or the
Sole Proprietorships joint venture, or other unincorporated organi-
zation that is carrying on a business and is
partners include the profits or losses of the A sole proprietorship is the simplest form of not classified as a trust, estate, or
business on their personal income tax re- business organization. This form of business corporation.
turns. Profits of a corporation are taxed both has no existence apart from you, the owner. A joint undertaking to share expenses is
to the corporation and to the shareholders Its liabilities are your personal liabilities, and not a partnership. Mere co-ownership of
when the profits are distributed as dividends. your ownership (proprietary) interest ends property maintained and leased or rented is
Also, losses sustained by the corporation when you die. You undertake the risks of not a partnership. However, if the co-owners
usually are not available to its stockholders. business to the extent of all your assets,
provide services to the tenants, then a part-
These two corporate rules do not apply to S whether used in the business or used
nership exists.
corporations. (S corporations are discussed personally.
in chapter 30.)
The tax considerations related to the Partnership agreement. The partnership
Profit or loss. When you figure your taxable
costs of getting started in a business are dis- agreement includes the original agreement
income for the year, you must add in any
cussed under Going Into Business in chapter profit, or subtract any loss, you have from and any modifications of it agreed to by all
4. your sole proprietorship. You must report the the partners or adopted in any other manner
profit or loss from each of your businesses provided by the partnership agreement. The
agreement or modifications may be oral or
Topics operated as a sole proprietorship on a sepa-
This chapter discusses: rate Schedule C (Form 1040). You can file written.
Schedule C–EZ (Form 1040) only if you had The partnership agreement may be mod-
● Sole proprietorships ified for a particular tax year after the close of
one business as a sole proprietor and you
● Partnerships meet the requirements in Part I of the sched- that year, but not later than the date, exclud-
ule. The amount of this business profit or ing any extension of time, for filing the part-
● Corporations
loss is then entered as an item of profit or nership return.
● S corporations loss on your individual income tax return Generally, a partner’s share of income,
● Taxpayer identification numbers Form 1040. gain, loss, deductions, or credits is deter-
If you are a sole proprietor, you are prob- mined by the partnership agreement.
Useful Items ably liable for self-employment tax (see However, the partnership agreement or
You may want to see: chapter 32). Also, ordinarily you will have to any modification of it will be disregarded if
make estimated tax payments (see chapter the allocation to a partner under the agree-
Publication 27). ment of income, gain, loss, deduction, or
credit (or of any item in these categories)
□ 1635 Understanding Your EIN does not have substantial economic effect.
Assets. Each asset in your sole proprietor-
ship is treated separately for tax purposes, In any matter on which the partnership
Form (and Instructions) rather than as part of one overall ownership agreement, or any modification of it, is silent,
□ SS–4 Application for Employer interest. For example, a sole proprietor sell- the provisions of local law are treated as part
Identification Number ing an entire business as a going concern of the agreement.
Chapter 1 INITIAL CONSIDERATIONS Page 5
Partnerships excluded. If all the members Income tax return. A corporation must file To make the election to become an S
agree, some partnerships may choose to be an income tax return unless it has dissolved. corporation, a corporation, in addition to
completely or partially excluded from being This applies even if it has ceased doing busi- other requirements, must not have more
treated as partnerships, for federal income ness and has disposed of all of its assets ex- than 35 shareholders. Also, each share-
tax purposes. The exclusion applies only to cept for a small sum of cash retained to pay holder must consent to the election.
certain unincorporated investing partner- state taxes to keep its corporate charter. A For more information on S corporations,
ships and operating agreements where busi- corporation may be required to file a return see chapter 30.
ness is not actively conducted. It applies to for any year following the year in which it has
the joint production, extraction, or use of been dissolved, if it carries on substantial ac-
property, but not for selling services or prop- tivities such as the collection of assets or the
erty produced or extracted. The members of payment of obligations in connection with Taxpayer Identification
such an organization must be able to figure
their income without having to figure partner-
the termination of its business affairs.
A corporation with no assets is not re-
Number
ship taxable income. quired to file an income tax return after it You generally use your social security
For more information on partnerships, stops doing business and dissolves. This is number as your taxpayer identification num-
see chapter 28. so even if it is treated as a corporation under ber. You must put this number on each of
state law for limited purposes connected your individual income tax forms, such as
with winding up its affairs, such as suing or Form 1040 and its schedules.
being sued. Most corporations file Form However, every partnership, corporation
Corporations 1120 or Form 1120–A. (including S corporations), and certain sole
proprietors must have an employer identifi-
Corporate profits normally are taxed to the Forming a corporation. Forming a corpo- cation number (EIN) to use as a taxpayer
corporation. When the profits are distributed ration involves a transfer of either money, identification number. Sole proprietors must
as dividends, the dividends are taxed to the property, or both, by the prospective share- have EINs if they:
shareholders. holders in exchange for capital stock in the
In figuring its taxable income, a corpora- 1) Pay wages to one or more employees,
corporation.
tion generally takes the same deductions as or
If money is exchanged for stock, no gain
a sole proprietorship. Corporations also are or loss is realized by the shareholder or the 2) Must file any pension or excise tax re-
entitled to special deductions that are dis- corporation. The stock received by the turns, including those for alcohol, to-
cussed in chapter 29. shareholder has a basis equal to the amount bacco, or firearms.
A corporation, for federal income tax pur- of money transferred to the corporation by
poses, includes associations, joint stock the shareholder. If you are required to have an EIN, in-
companies, insurance companies, and If property is exchanged for stock, it may clude it along with your social security num-
trusts and partnerships that actually operate be a nontaxable exchange of property for ber on your Schedule C (Form 1040). If you
as associations or corporations. stock, as discussed in chapter 21. In other are not required to have an EIN, use your so-
cases, the shareholder who transfers the cial security number as your business tax-
Organizations of professional people. property to the corporation will realize a tax- payer identification number. Enter it on the
Organizations of doctors, lawyers, and other able gain or loss. Under certain circum- appropriate line and leave line D blank.
professional people organized under state stances, as explained under Sales and Ex-
professional association acts are generally changes Between Related Parties in chapter Application for identification number. To
recognized as corporations for federal in- 22, any gain recognized which ordinarily apply for a social security number, you
come tax purposes. A professional service would be a capital gain may have to be should use Form SS–5. If you are under 18
organization must be both organized and treated as an ordinary gain, and any loss years of age, you must furnish evidence,
operated as a corporation to be classified may be nondeductible. along with this form, of age, identity, and U.S.
as one. All of the states and the District of The gain or loss on a taxable exchange citizenship. If you are 18 or older, you must
Columbia have professional association is figured by comparing the adjusted basis of appear in person with this evidence at a So-
acts. the property transferred with its fair market cial Security office. If you are an alien, you
value at the time of the transfer to the corpo- must appear in person and bring your birth
Unincorporated organizations. Organiza- ration. This may be a capital gain or loss. certificate and either your alien registration
tions that are unincorporated and have cer- See chapter 22. card or your U.S. immigration form.
tain corporate characteristics are classified For more information on corporations, To apply for an EIN, use Form SS–4. This
as associations and are taxed as corpora- see chapter 29. form is available from IRS and Social Secur-
tions. These organizations must have asso- ity Administration offices.
ciates and must be organized to carry on
Payments to others. If you make payments
business and divide any gains from the busi-
ness. In addition, the organizations must
S Corporations that require an information return, you must
have a majority of the following A qualifying corporation may choose to be include the payee’s taxpayer identification
characteristics: generally exempt from federal income tax. number on the information return. See chap-
Its shareholders will then include in their in- ter 36.
1) Continuity of life,
come their share of the corporation’s sepa- To get the payee’s number, use Form
2) Centralization of management, rately stated items of income, deduction, W–9. This form is available from the IRS. A
3) Limited liability, and loss, and credit and their share of non- payee who does not provide you with an
separately stated income or loss. A corpora- identification number may be subject to
4) Free transferability of interests. tion that makes this choice is an S backup withholding of 31% on the payments
corporation. you make.
Other factors may also be significant in Although it generally will not be liable for Penalties. A penalty of up to $50 per re-
classifying an organization as an associa- federal income tax, an S corporation may turn applies for each failure to comply by the
tion. An organization will be treated as an as- have to pay a tax on excess net passive in- required due date with certain specified in-
sociation if its characteristics more nearly re- vestment income, a tax on capital gains, a formation reporting requirements, up to a
semble a corporation than a partnership or tax on built-in gains, or the tax from recom- maximum of $100,000 for all such failures.
trust. The facts in each case determine puting a prior year’s investment credit. An S Most of these requirements concern furnish-
which characteristics are present. corporation files its return on Form 1120S. ing and including taxpayer identification
Page 6 Chapter 1 INITIAL CONSIDERATIONS
numbers on returns, statements, and other 3) A partnership incorporates; 1) You purchase or inherit an existing busi-
documents. See chapter 36 for more infor- ness that you will operate as a sole pro-
4) A partnership is taken over by one of the
mation on penalties. prietorship (You cannot use the EIN of
partners and is operated as a sole pro-
prietorship; or the former owner, even if he or she is
New EIN. You may need to get a new EIN if your spouse.);
either the form or the ownership of your busi- 5) A corporation changes to a partnership
ness changes. or to a sole proprietorship. 2) You represent an estate that operates a
Change in organization. A new EIN is business after the owner’s death; or
required for the following changes: Note. A corporation converting to an S
1) A sole proprietorship incorporates; corporation does not need a new EIN. 3) You terminate an old partnership and
begin a new one.
2) A sole proprietorship takes in partners Change in ownership. A new EIN is re-
and operates as a partnership; quired for the following changes:
Chapter 1 INITIAL CONSIDERATIONS Page 7
Prepare your tax returns. You need good 4) The amount of withholding tax collected
records to prepare your tax return. These on each payment and the date it was
2. records must support the income, expenses,
and credits you report. Generally, these are
collected.
5) If the taxable amount is less than the to-
the same records you use to monitor your
Books and bus in e s s a n d p r e p a r e y o u r f i n a n c i a l
tal payment, the reason why it is less.
6) Copies of any statements furnished by
statements.
Records employees relating to nonresident alien
status, residence in Puerto Rico or the
Support items reported on tax returns.
Virgin Islands, or residence or physical
You must keep your business records availa-
presence in a foreign country.
Topics ble at all times for inspection by the IRS. If
This chapter discusses: the IRS examines any of your tax returns, 7) The fair market value and date of each
you may be asked to explain the items re- payment of noncash compensation
● Why you should keep records made to a retail commission salesper-
ported. A complete set of records will speed
● What records to keep up the examination. son, if no income tax was withheld.
● How long to keep records 8) For accident or health plans, informa-
tion about the amount of each payment.
Useful Items Kinds of Records To 9) The withholding allowance certificates
(Form W–4) filed by each employee.
You may want to see:
Keep 10) Any agreement between you and the
Publication Except in a few cases, the law does not re- employee on Form W-4 for the volun-
quire any special kind of records. You may tary withholding of additional amounts
□ 463 Travel, Entertainment, and Gift
choose any system suited to your business of tax.
Expenses
that clearly shows your income. 11) If necessary to figure tax liability, the
□ 583 Starting a Business and Keeping The business you are in affects the type dates in each calendar quarter on which
Records of records you need to keep for federal tax any employee worked for you, but not in
□ 917 Business Use of a Car purposes. You should set up your books us- the course of your trade or business,
ing an accounting method that clearly shows and the amount paid for that work.
your income for your tax year. See chapter 3. 12) Copies of statements given to you by
You must keep records to correctly figure If you are in more than one business, you employees reporting tips received in
your taxes. This chapter explains why you should keep a complete and separate set of their work, unless the information
must keep records, what kinds of records books for each business. shown on the statements appears in an-
you must keep, and how long you must keep Your books must show your gross in- other item on this list.
them for federal tax purposes. come, as well as your deductions and cred-
13) Requests by employees to have their
If you are starting a new business, get its. In addition, you must keep supporting
withheld tax figured on the basis of their
Publication 583. It has more details about documents. Purchases, sales, payroll, and
individual cumulative wages, and any
setting up a recordkeeping system. other transactions you have in your business
notice that the request was revoked.
will generate supporting documents such as
invoices and receipts. These documents 14) The Forms W–5, Earned Income Credit
contain the information you need to record in Advance Payment Certificate, and the
Why Keep Records? your books. amounts and dates of the advance
It is important to keep these documents payments.
Everyone in business must keep records.
Good records will help you do the following. because they support the entries in your
books and on your tax return. You should An employee’s earnings ledger, which
keep them in an orderly fashion and in a safe you can buy at most office supply stores,
Monitor the progress of your business. normally has space for the information re-
You need good records to monitor the pro- place.
quired in items (1) to (4).
gress of your business. Records can show Social security and Medicare taxes.
whether your business is improving, which Travel, transportation, entertainment,
and gift expenses. Special recordkeeping You must also maintain the following infor-
items are selling, or what changes you need mation in your records on the social security
to make. Good records can increase the like- rules apply to these expenses. For more in-
formation, see Publication 463, Travel, En- and Medicare taxes of your employees:
lihood of business success.
tertainment, and Gift Expenses and Publica- 1) The amount of each wage payment sub-
Prepare your financial statements. You tion 917, Business Use of a Car. ject to social security tax.
need good records to prepare accurate fi- 2) The amount of each wage payment sub-
nancial statements. These include income Employment taxes. The following is a list ject to Medicare tax.
(profit and loss) statements and balance of the specific employment tax records you
3) The amount of social security and Medi-
sheets. These statements can help you in must keep. For information on the employ-
care tax collected for each payment and
dealing with your bank or creditors. ment taxes you may have to pay, see chap-
the date collected.
ter 33.
Income tax withholding. The specific 4) If the total wage payment and the taxa-
Identify source of receipts. You will re-
records you must keep for income tax with- ble amount differ, the reason why they
ceive money or property from many sources.
holding are: do.
Your records can identify the source of your
receipts. You need this information to sepa- 1) Each employee’s name, address, and Federal unemployment (FUTA) tax.
rate business from nonbusiness receipts social security number. For FUTA tax purposes, you must maintain
and taxable from nontaxable income.
2) The total amount and date of each records containing the following information:
wage payment and the period of time 1) The total amount paid to your employ-
Keep track of deductible expenses. You
the payment covers. ees during the calendar year.
may forget expenses when you prepare your
tax return unless you record them when they 3) For each wage payment, the amount 2) The amount of compensation subject to
occur. subject to withholding. the unemployment tax, and, if it differs
Page 8 Chapter 2 BOOKS AND RECORDS
from the total compensation, why it 3) An account statement showing a credit provision of the Internal Revenue Code.
differs. card charge (an increase to the card- Generally, this means you must keep
holder’s loan balance) is accepted as records that support an item of income or
3) The amount you paid into the state un- proof if it shows the: deduction on a return until the period of limi-
employment fund.
tations for that return runs out.
4) Any other information required to be a) Amount charged, The period of limitations is the period of
shown on Form 940 (or Form 940–EZ). time in which you can amend your return to
b) Payee’s name, and claim a credit or refund, or the IRS can as-
Assets. Assets are the property, such as sess additional tax. The period of time in
machinery and furniture, that you own and c) Date charged (transaction date). which you can amend your return to claim a
use in your business. You must keep records credit or refund is generally the later of:
to verify certain information about your busi-
ness assets. You need records to figure the These account statements must be
annual depreciation and the gain or loss highly legible and readable. 1) 3 years after the date your return is due
when you sell the assets. Your records Proof of payment of an amount alone or filed, or
should show: does not establish that you are entitled to a
tax deduction. You should also keep other
● When and how you acquired the asset documents, such as credit card sales slips 2) 2 years after the date the tax is paid.
and invoices, discussed previously.
● Purchase price
● Cost of any improvements
Computerized system. There are com- Returns filed before the due date are treated
● Section 179 deduction taken puter software packages that you can use as filed on the due date.
for recordkeeping. They can be purchased in The IRS has 3 years from the date you
● Deductions taken for depreciation many retail stores. These packages are very file your return to assess any additional tax. If
● Deductions taken for casualty losses, useful and relatively easy to use; they require you file a fraudulent return or no returns at
such as fires or storms very little knowledge of bookkeeping and
all, the IRS has a longer period of time to as-
accounting.
● How you used the asset sess additional tax.
If you use a computerized system, you
● When and how you disposed of the asset must be able to produce legible records from
the system to provide the information
● Selling price needed to determine your correct tax Employment taxes. If you have employ-
liability. ees, you must keep all employment tax
● Expenses of sale You must also keep all machine-sensible records for at least 4 years after the date the
records and a complete description of the tax becomes due or is paid, whichever is
Examples of records that may show this computerized portion of your accounting later.
information include: system. This documentation must be suffi-
ciently detailed to show the following:
● Purchase and sales invoices
● Real estate closing statements 1) Applications being performed, Assets. Keep records relating to property
until the period of limitations expires for the
● Canceled checks
2) Procedures used in each application, year in which you dispose of the property in a
taxable disposition. You must keep these
What if I don’t have a canceled check? If 3) Controls used to ensure accurate and records to figure any depreciation, amortiza-
you do not have a canceled check, you may reliable processing, and tion, or depletion deduction, and to figure
be able to prove payment with certain finan- your basis for computing gain or loss when
cial account statements prepared by finan- 4) Controls used to prevent the unautho- you sell or otherwise dispose of the property.
cial institutions. These include account rized addition, alteration, or deletion of Generally, if you received property in a
statements prepared for the financial institu- retained records. nontaxable exchange, your basis in that
tion by a third party. The following is a list of
property is the same as the basis of the prop-
acceptable account statements.
erty you gave up. You must keep the records
1) An account statement showing a check See Revenue Procedure 91–59, printed in on the old property, as well as on the new
clearing is accepted as proof if it shows Cumulative Bulletin 1991–2 on page 841 for property, until the period of limitations ex-
the: more information. pires for the year in which you dispose of the
new property in a taxable disposition.
a) Check number,
Microfilm. Microfilm and microfiche repro-
b) Amount, ductions of general books of accounts, such
c) Payee’s name, and as cash books, journals, voucher registers, Tax returns. Keep copies of your filed tax
and ledgers, are accepted for recordkeeping returns. They help in preparing future tax re-
d) Date the check amount was posted to purposes if they comply with Revenue Pro- turns and making computations if you later
the account by the financial cedure 81–46, printed in Cumulative Bulletin file an amended return.
institution. 1981–2 on page 621.
2) An account statement showing an elec-
tronic funds transfer is accepted as
Records for nontax purposes. When your
proof if it shows the:
a) Amount transferred,
How Long To Keep records are no longer needed for tax pur-
poses, do not discard them until you check
b) Payee’s name, and
Records to see if you have to keep them longer for
other purposes. For example, your insurance
c) Date the transfer was posted to the You must keep your records as long as they company or creditors may require you to
account by the financial institution. may be needed for the administration of any keep them longer than the IRS does.
Chapter 2 BOOKS AND RECORDS Page 9
If you do not regularly use an accounting must use the calendar year for federal unem-
method that clearly shows your income, your ployment tax. Employment taxes are dis-
3. income will be figured under the method
that, in the opinion of the IRS, clearly shows
cussed in chapter 33.
Accounting your income.
Short Tax Year
A short tax year is a tax year of less than 12
Periods and Topics
This chapter discusses: months. There are two situations that can re-
sult in a short tax year. The first occurs when
Methods ● Calendar tax years you (as a taxable entity) are not in existence
● Fiscal tax years for an entire tax year. The second occurs
● Short tax years when you change your accounting period.
Each situation results in a different way of
● Accounting methods figuring tax for the short tax year.
Introduction ● Cash method
Every taxpayer (business or individual) must Not in existence entire year. A tax return is
● Accrual method
figure taxable income and file a tax return on required for the short period during which
● Change in accounting method you were in existence. Requirements for fil-
the basis of an annual accounting period.
Your ‘‘tax year’’ is the annual accounting pe- ing the return and paying the tax generally
riod you use for keeping your records and re- Useful Items are the same as if the return were for a full
porting your income and expenses. The ac- You may want to see: tax year of 12 months that ended on the last
counting periods you can use are: day of the short tax year.
Publication Example. Corporation X came into exis-
1) A calendar year, or
□ 538 Accounting Periods and Methods tence on July 1, 1995. It elected the calendar
2) A fiscal year. year as its tax year. Corporation X must file
Form (and Instructions) its return by March 15, 1996. The return cov-
You adopt a tax year when you file your first ers the period July 1, 1995, through Decem-
□ 1128 Application To Adopt, Change,
income tax return. You must adopt your first ber 31, 1995.
or Retain a Tax Year
tax year by the due date (not including exten-
sions) for filing a return for that year. □ 3115 Application for Change in Change in accounting period. You must,
The due date for individual and partner- Accounting Method with certain exceptions, get approval from
ship returns is the 15th day of the 4th month the IRS to change your accounting period.
after the end of the tax year. Individuals in- To get this approval, you must file a current
Form 1128 and enclose a user fee. This form
clude sole proprietors, partners, and S cor-
poration shareholders. The due date for fil-
Accounting Periods must be filed by the 15th day of the 2nd cal-
ing returns for corporations and S Your regular accounting period is either a endar month after the close of the short tax
corporations is the 15th day of the 3rd month calendar tax year or a fiscal tax year. year. This short tax year begins on the first
after the end of the tax year. If the 15th day day after the end of your present tax year
of the month falls on a Saturday, Sunday, or Calendar Tax Year and ends on the day before the first day of
legal holiday, the due date is the next day your new tax year.
If you adopt the calendar year for your an-
that is not a Saturday, Sunday, or legal Example. You use a calendar tax year
nual accounting period, you must maintain
holiday. and, in 1996, you want to change to a fiscal
your books and records and report your in-
An accounting method is a set of rules year ending October 31. You must file Form
come and expenses for the period from Jan-
used to determine when and how income 1128 by December 16, 1996.
uary 1 through December 31 of each year.
and expenses are reported. Your ‘‘account- If you change your accounting period,
You must adopt the calendar tax year if:
ing method’’ includes not only the overall you figure your tax for the short tax year by
method of accounting you use, but also the 1) You do not keep adequate records, placing your taxable income for the short pe-
accounting treatment you use for any mate- 2) You have no annual accounting period, riod on an annual basis. This computation,
rial item. or and other rules regarding a change in ac-
You choose your accounting method counting period are explained in Publication
3) Your present tax year does not qualify
when you file your first tax return. After that, 538.
as a fiscal year.
if you want to change your accounting
method, you must first get consent from the
IRS. See Change in Accounting Method,
Individuals
Fiscal Tax Year Individuals generally use a calendar tax year.
later.
If you filed your first return using the calendar
No single accounting method is required A regular fiscal tax year is 12 consecutive
tax year, and you later begin business as a
of all taxpayers. You must use a system that months ending on the last day of any month
sole proprietor, or become a partner, or be-
clearly shows your income and expenses except December. A 52–53 week year is a
come a shareholder in an S corporation, you
and you must maintain records that will en- fiscal tax year that varies from 52 to 53
must continue to use the calendar tax year
able you to file a correct return. In addition to weeks.
unless you get permission to change. You
your permanent books of account, you must If you adopt a fiscal tax year, you must
must report your income from all sources, in-
keep any other records necessary to support maintain your books and records and report
cluding your sole proprietorship, salaries,
the entries on your books and tax returns. your income and expenses using the same
partnership income, and dividends, using the
You must use the same method from tax year.
same tax year.
year to year. Any accounting method that For more information on fiscal years in-
shows the consistent use of generally ac- cluding 52–53 week years, get Publication
cepted accounting principles for your trade 538. Partnerships
or business generally is considered to clearly A partnership must conform its tax year to its
show income. An accounting method clearly Note. Employment taxes are figured on partners’ tax years, unless the partnership
shows income only if all items of gross in- a calendar year basis. You must use the cal- can establish a business purpose for a differ-
come and all expenses are treated the same endar quarter for withheld income tax and ent period or makes a section 444 election.
from year to year. social security and Medicare taxes. You A partnership is required to conform its tax
Page 10 Chapter 3 ACCOUNTING PERIODS AND METHODS
year to its partners’ tax years in the following performing arts, or certain consulting ser- separate and distinct business if the method
way: vices, is considered to be the performance you use for each clearly shows your income.
1) If a majority interest (aggregate interest of personal services. For example, if you operate a personal ser-
of more than 50%) in partnership capital For additional information about a per- vice business and a manufacturing business,
and profits is held by one partner, or by sonal service corporation’s tax year, see you may use the cash method for the per-
more than one partner with the same Publication 538. sonal service business but you must use an
tax year, the partnership must adopt accrual method for the accounting of the
that tax year. manufacturing business’ sales and
purchases.
2) If there are no partners who own a ma- Accounting Methods No business will be considered separate
jority interest, or if the majority interest and distinct if you do not keep a complete
Generally, you may figure your taxable in-
partners do not have the same tax year, and separable set of books and records for
come under any of the following accounting
the partnership is required to change to that business.
methods:
the tax year of its principal partners. A
principal partner is one who has a 5% or 1) Cash method,
more interest in the profits or capital of 2) Accrual method,
Cash Method
the partnership. The cash method of accounting is used by
3) Special methods of accounting for cer- most individuals and many small businesses
3) If neither (1) nor (2) applies, the partner- tain items of income and expenses, and
ship is required to adopt a tax year that with no inventories. However, if inventories
results in the least aggregate deferral of 4) Combination (hybrid) method using ele- are necessary in accounting for your income,
income to the partners. ments of two or more of the above. you must use an accrual method for your
sales and purchases. If you do not have to
For more information about the required year The cash and accrual methods of account- keep inventories, you usually will use the
for partnerships, establishing a business pur- ing are explained later. cash method. However, see Limits on Use of
pose tax year, and a section 444 election, Special methods. There are special Cash Method, next.
see Publication 538. For general information methods of accounting for certain items of
on partnerships, see chapter 28. income or expense such as: Limits on Use of
Depreciation, discussed in chapter 12, Cash Method
S Corporations Amortization and depletion, discussed in The cash method, including any combination
A small business corporation can elect to be chapter 13, of methods that includes the cash method,
an S corporation. All S corporations, regard- cannot be used by the following entities:
Deduction for bad debts, discussed in
less of when they became S corporations, chapter 14, and 1) Corporations (other than S
must use a calendar tax year, or any other corporations),
Installment sales, discussed in chapter
tax year for which the corporation estab-
24. 2) Partnerships having a corporation
lishes a business purpose or makes a sec-
(other than an S corporation) as a part-
tion 444 election. For information on estab-
Combination (hybrid) method. Gener- ner, and
lishing a business purpose tax year or a
section 444 election, get Publication 538. ally, you may use any combination of cash, 3) Tax shelters.
For general information on S corporations, accrual, and special methods of accounting
see chapter 30. if the combination clearly shows income and Exceptions. An exception allows farming
you use it consistently. However, the follow- businesses with gross receipts of $25 million
ing restrictions apply: or less, qualified personal service corpora-
Corporations 1) If inventories are necessary to account tions, and entities with average annual gross
A new corporation establishes its tax year
for your income, you must use an ac- receipts of $5 million or less to use the cash
when it files its first income tax return. It can
crual method for purchases and sales. method. However, these exceptions do not
use either a calendar year or a fiscal year as
You can use the cash method for all apply to tax shelters. For more general infor-
its tax year. However, special rules exist that
other items of income and expenses. mation, see Publication 538. For more infor-
limit your tax year choice if you are a per-
See Inventories, in the discussion of ex- mation on the farming exception, see chap-
sonal service corporation, S corporation,
penses under Accrual Method, later. ter 3 in Publication 225.
member of an affiliated group filing a consoli-
dated return, real estate mortgage invest- 2) If you use the cash method for figuring
ment conduit, foreign sales corporation, or your income, you must use the cash Income
domestic international sales corporation. method for reporting your expenses. With the cash method, you include in your
3) If you use an accrual method for report- gross income all items of income you actu-
Personal Service Corporations ing your expenses, you must use an ac- ally or constructively receive during the year.
Personal service corporations must use a crual method for figuring your income. You must include property and services you
calendar tax year unless they can establish a receive in your income at their fair market
business purpose for a different period, or Any combination that includes the cash value.
make a section 444 election. For this pur- method is treated as the cash method, sub-
pose, a personal service corporation gener- ject to the limitations applied to that method. Constructive receipt. You have construc-
ally is a corporation in which the principal ac- tive receipt of income when an amount is
tivity is the performance of personal services Business and personal items. You may credited to your account or made available
that are substantially performed by em- account for business and personal items to you without restriction. You do not need to
ployee-owners. For information on establish- under different accounting methods. For ex- have possession of it. If you authorize some-
ing a business purpose tax year or a section ample, you may figure the income from your one to be your agent and receive income for
444 election, get Publication 538. business under an accrual method even you, you are treated as having received it
though you use the cash method to figure when your agent receives it.
Performance of personal services. For personal items. Example 1. You have interest credited
this purpose, any activity that involves the to your bank account in December 1995.
performance of services in the fields of Two or more businesses. If you operate You must include it in your gross income for
health, veterinary services, law, engineering, more than one business, you generally may 1995 and not for 1996 when you withdraw it
architecture, accounting, actuarial science, use a different accounting method for each or enter it in your passbook.
Chapter 3 ACCOUNTING PERIODS AND METHODS Page 11
Example 2. You have interest coupons Change in payment schedule for ser- purchases and sales. Inventories are dis-
that mature and are payable in 1995, but you vices. If you contract to perform services for cussed in chapter 7.
do not cash them until 1996. You must in- a basic rate, you must include the basic rate
clude them in income for 1995. You must in- in your income as it accrues. You must ac- Special Rules for Related
clude this matured interest in your gross in- crue the basic rate even if, as a matter of Persons
come even though you later exchange the convenience, you agree to receive pay-
You cannot deduct business expenses and
coupons for other property instead of cash- ments at a lower rate until you complete your
interest owed to a related cash basis person
ing them. services, at which time you will receive the
until you make the payment and the corre-
Delaying receipt of income. You can- difference between the basic rate and the
sponding amount is includible in the gross in-
not hold checks or postpone taking posses- amount actually paid to you.
come of the related person. Determine the
sion of similar property from one tax year to relationship, for this rule, as of the end of the
another to avoid paying the tax on the in- Accounts receivable for services. You tax year for which the expense or interest
come. You must report the income in the may not have to accrue all of your accounts would otherwise be deductible. If a deduc-
year the property is made available to you receivable if, based on your experience, you tion is denied under this rule, the rule will
without restriction. will not collect all of these accounts. This is continue to apply even if your relationship
called the nonaccrual-experience method. with the person ends before the expenses or
See section 1.448–2T(b) of the Income Tax interest is includible in the gross income of
Expenses Regulations. that person.
Usually, you must deduct expenses in the
tax year in which you actually pay them. Expenses Related persons. For the purpose of apply-
However, expenses you pay in advance can
You deduct or capitalize business expenses ing this rule, the following are related
be deducted only in the year to which they
when you become liable for them, whether persons:
apply. In addition, if the uniform capitaliza-
tion rules apply (see chapter 7), you may or not you pay them in the same year. For 1) Members of the immediate family, in-
have to capitalize certain costs. this purpose, liability occurs in the tax year in cluding only brothers and sisters (either
which you meet the all events test and the whole or half), husband and wife, an-
Example. You are a calendar year tax- economic performance rule. cestors, and lineal descendants.
payer and you pay $1,000 for a business in-
surance policy that is effective on July 1, 2) Two corporations that are members of
All events test. Before you can deduct or
1995, for a one-year period. You may deduct the same controlled group.
capitalize the expenses, all events must
$500 in 1995 and $500 in 1996. have occurred that fix the fact of the liability 3) The fiduciaries of two different trusts,
and you must be able to figure the amount and the fiduciary and beneficiary of two
with reasonable accuracy. different trusts if the same person is the
Accrual Method grantor of both trusts.
Under an accrual method of accounting, in-
Economic performance rule. Generally, 4) Certain educational and charitable orga-
come generally is reported in the year
you cannot deduct business expenses until nizations and a person (if an individual,
earned, and expenses are deducted or capi-
economic performance occurs. If your ex- including the members of the individu-
talized in the year incurred. The purpose of
pense is for property or services provided to al’s family) who, directly or indirectly,
an accrual method of accounting is to match you, or for use of property by you, economic controls the organization.
your income and your expenses in the cor- performance occurs as the property or ser-
rect year. 5) An individual and a corporation of which
vices are provided or as the property is used. more than 50% of the value of the out-
If your expense is for property or services standing stock is owned, directly or indi-
Income that you provide to others, economic per- rectly, by or for that individual.
Generally, all items of income are included in formance occurs as you provide the property
or services. An exception allows certain re- 6) A trust fiduciary and a corporation of
your gross income when you earn them,
curring expenses to be treated as incurred which more than 50% in value of the
even though you may receive payment in an-
during a tax year even though economic per- outstanding stock is owned, directly or
other tax year. An income item is includible in
formance has not occurred. indirectly, by or for the trust or by or for
your gross income in the tax year in which all
the grantor of the trust.
events that fix your right to receive the in- Example. You are a calendar year tax-
come have happened, and you can figure payer and in December 1995 you buy office 7) The grantor and fiduciary, and the fiduci-
the amount with reasonable accuracy. supplies. You received the supplies and are ary and beneficiary, of any trust.
billed for them in December, but you pay for 8) Any two S corporations if the same per-
Example. You are a calendar year ac-
the supplies in January 1996. You can de- sons own more than 50% in value of the
crual basis taxpayer. You sold a computer on
duct the expense in 1995 because all events outstanding stock of each corporation.
December 28, 1995. You billed the customer
that fix the fact of liability have occurred, the
in the first week of January 1996, but you did 9) An S corporation and a corporation that
amount of the liability can be reasonably de-
not receive payment until February 1996. is not an S corporation if the same per-
termined, and economic performance oc-
You must include the amount of the sale in sons own more than 50% in value of the
curred in that year.
your income for 1995 because you earned outstanding stock of each corporation.
Your office supplies may qualify as a re-
the income in 1995. 10) A corporation and a partnership if the
curring expense. In that case, you may be
able to deduct the expense in 1995 even if same persons own more than 50% in
Advance income. Special rules dealing economic performance (delivery of the sup- value of the outstanding stock of the
with an accrual method of accounting for ad- plies to you) did not occur until 1996. See corporation and more than 50% of the
vance payments to you are discussed in Publication 538 for more information on the capital interest or profits or profits inter-
chapter 6 under Prepaid Income. economic performance requirement. est in the partnership.
11) A personal service corporation and any
Estimating income. When you include an Inventories. Inventories are necessary to employee-owner, regardless of the
amount in gross income on the basis of a clearly show income when the production, amount of stock owned by the em-
reasonable estimate, and you later deter- purchase, or sale of merchandise is an in- ployee-owner.
mine the exact amount, the difference, if come-producing factor. If inventories are
any, is taken into account in the tax year in necessary to show income correctly, only an Indirect ownership of stock. To decide
which the determination is made. accrual accounting method can be used for whether an individual directly or indirectly
Page 12 Chapter 3 ACCOUNTING PERIODS AND METHODS
owns any of the outstanding stock of a cor- Gains and losses. Gains and losses on 1) A change from the cash method to an
poration, the following rules apply: sales or exchanges between related par- accrual method or vice versa (unless
1) Stock owned, directly or indirectly, by or ties are discussed in chapter 21. For infor- you must change to an accrual method
for a corporation, partnership, estate, or mation on losses from sales or exchanges of and you make the change
trust is treated as being owned propor- property between partners and partnerships, automatically),
tionately by or for its shareholders, part- see chapter 28.
ners, or beneficiaries. 2) A change in the method or basis used to
Change in value inventories, and
2) An individual is treated as owning the
stock owned, directly or indirectly, by or Accounting Method 3) A change in the method of figuring de-
for the individual’s family (as defined in
When you file your first return, you may, with- preciation (except certain changes to
item (1) under Related persons).
out consent from the IRS, choose any per- the straight line method as explained in
3) Any individual owning (other than by ap- mitted accounting method. The method you chapter 12).
plying rule (2)) any stock in a corpora- choose must be used consistently from year
tion is treated as owning the stock to year and clearly show your income.
owned directly or indirectly by that indi- After your first return is filed, if you want Automatic change to accrual method. If
vidual’s partner, and to change your accounting method, you you are required to change from the cash
4) Stock constructively owned by a person must first get consent from the IRS. method to an accrual method, discussed
under rule (1), shall, to apply rule (1), (2), The IRS will consider the need for con- earlier under Limits on Use of Cash Method,
or (3), be treated as actually owned by sistency in the accounting area against your you are not required to have prior approval
that person. But stock constructively reason for wanting to change your account- from the IRS to make this change.
owned by an individual under rule (2) or ing method when the method from which you Form 3115. Although this change to an
(3) will not be treated as actually owned are changing clearly shows your income. overall accrual method is considered auto-
by the individual for applying either rule If you request a change in accounting matic, you must complete and file Form
(2) or (3) to make another person the method (such as from an improper to a 3115 by the due date (including extensions)
constructive owner of that stock. proper method), the absence of IRS consent for filing your income tax return. Attach Form
to the change does not prevent the IRS from 3115 with the applicable user fee to your in-
Reallocation of income and deductions. imposing any penalty or addition to tax, nor come tax return. For more information, see
Where it is necessary to clearly show income diminish the amount of the penalty or the ad- Publication 538.
or to prevent evasion of taxes, the IRS may dition to tax.
reallocate gross income, deductions, cred- A change in your accounting method in-
its, or allowances between two or more orga- cludes a change not only in your overall sys- Accounting change information. For in-
nizations, trades, or businesses owned or tem of accounting but also in the treatment formation about the procedures to change
controlled directly or indirectly by the same of any material item. Some examples of your accounting method, see Publication
interests. changes that require consent are: 538.
Chapter 3 ACCOUNTING PERIODS AND METHODS Page 13
Part Two.
Business Whether you are starting a new business or are continuing a going one, you
probably need to acquire property to use in your business. The cost of this
property becomes part of the capital investment in your business. This Part
Assets discusses the kinds of costs that must be capitalized and how to figure the
basis of your business assets.
7 for a discussion of the uniform capitaliza- of costs that can be deducted when you
tion rules that apply to property produced for have them after you open for business.
4. sale or purchased for resale. The costs of going into business are dis-
cussed later in this chapter.
Capital Topics
This chapter discusses:
3) Improvements. The costs of making
improvements to a business asset are
Expenses ● Kinds of capital expenses capital expenses if the improvements
add to the value of the asset, apprecia-
● Business assets
bly lengthen the time you can use it, or
● Going into business adapt it to a different use. However, nor-
● Costs you can choose to deduct or mal repair costs are deducted as busi-
Introduction capitalize ness expenses and are not capitalized.
Ordinarily, you add the cost of the im-
You must capitalize (charge an expense to a provement to the basis of the improved
capital asset account), rather than deduct, Useful Items
You may want to see: property. The cost of the improvement
some costs. These costs are considered a is recovered through annual deprecia-
part of your investment in your business and tion deductions. See chapter 12.
are called ‘‘capital expenses.’’ There are, in Publication
Examples of improvements are new
general, three types of costs that must be □ 946 How To Depreciate Property electric wiring, a new roof, a new floor,
capitalized: □ 535 Business Expenses new plumbing, bricking up windows to
1) Going into business, strengthen a wall, and lighting
Form (and Instructions) improvements.
2) Business assets, and
□ 6765 Credit for Increasing Research
3) Improvements. Restoration plan. Capitalize the cost of
Activities
reconditioning, improving, or altering your
These costs are discussed later. This chap- □ 3115 Application for Change in property as part of a general restoration plan
ter and the next discuss the treatment of Accounting Method to make it suitable for your business. This ap-
capital expenses. plies even if some of the work would by itself
be classified as repairs.
Cost of goods sold. If your business manu-
factures products or purchases them for re-
Kinds Of Capital Basis. When you make a capital expense, it
sale, some of your costs are for the products Expenses becomes a part of your ‘‘basis.’’ Basis is a
you sell. You use these expenses to figure way of measuring your investment in an as-
Generally, three kinds of costs must be
the cost of goods you sold during the year. set for tax purposes. It is used in many
capitalized:
Deduct these costs from your gross receipts ways—to figure gain or loss on a sale, to fig-
to figure your gross profit for the year. (You 1) Business assets. What you spend for ure the amount of a casualty loss, to figure
must maintain inventories to be able to de- any asset you will use in your business depreciation deductions, etc.
termine your cost of goods sold.) If you use for more than one year is a capital ex- Your original basis in an asset is the
an expense to figure cost of goods sold, you pense. There are many different kinds of amount you must spend to acquire it. But
cannot deduct it again as a business ex- business assets—for example, land, even if it does not cost you anything to ac-
pense. See the chapters in Part 3 for more buildings, machinery, trucks, books, fur- quire a business asset—for example, if you
information on gross profit and the cost of niture, patents, and franchise rights. inherit it or get it as a gift—you will still have a
goods sold. See chapter 7 for a discussion of You must capitalize the full cost of the basis in the asset. While you own the asset,
the uniform capitalization rules that apply to asset, including freight and installation various events may take place that will
property produced for sale or purchased for charges. Business assets are discussed change your basis in the property. Some
resale. later in this chapter. events, such as improvements or additions,
If you produce certain property for increase basis. Others, such as casualty
Business expenses. Most of the other op- use in your trade or business, capitalize losses or depreciation deductions, decrease
erating costs of your business can be de- the production costs under the uniform basis.
ducted from gross profit when figuring in- capitalization rules. See section 1.263A For more information on figuring basis,
come or loss for the year. These operating of the Income Tax Regulations for infor- see chapter 5.
costs are known as business expenses. mation on those rules.
Some of the business expenses that are de- 2) Going into business. The costs of get- Recovery. Although you generally cannot
ductible are advertising, office supplies, in- ting started in business, before you ac- directly deduct a capital expense, you can
surance premiums, employee wages, utili- tually begin business operations, are often ‘‘recover’’ your cost (i.e., subtract it
ties, rent, and property taxes. See the capital expenses. This may include ex- from income) one part at a time over a num-
chapters in Part 4 for information on deduct- penses for such things as advertising, ber of years. This is done by deducting a per-
ing business expenses, including the limits travel, utilities, repairs, and employees’ centage of basis each year under one of the
on what can be deducted. Also, see chapter wages. These are often the same kind following methods:
Page 14 Chapter 4 CAPITAL EXPENSES
1) Depreciation. Depreciation is used to cost of maintaining a private road on your 3) Pay salaries or fees for executives, con-
recover capital expenses for most tangi- business property is a deductible expense. sultants, and other professional
ble business assets. Tools. Unless the uniform capitalization services,
2) Amortization. Amortization is used to rules apply, amounts spent for tools used in 4) Begin to hire and train employees, or
recover only certain kinds of capital ex- your business are deductible expenses if the
tools have a life expectancy of less than one 5) Analyze available facilities, labor, sup-
penses, such as some research costs, plies, etc.
year.
business start-up costs, and the cost of
pollution control facilities. Machinery. Unless the uniform capitali-
zation rules apply, the cost of replacing However, because your business has not yet
3) Depletion. Depletion is used to recover short-lived parts of a machine to keep it in started active operations, you are not al-
the cost of an economic interest in tim- good working condition and not to add to its lowed to deduct these kinds of costs as ex-
ber, minerals, and other natural life is a deductible expense. penses. These costs, start-up costs, must be
resources. See section 1.263A of the Income Tax amortized. To be amortizable, a start-up cost
Regulations for information on the uniform must meet the following tests:
You can choose to deduct in one tax year capitalization rules. 1) It must be a cost that you could deduct if
a limited amount of what you spend to ac- Heating equipment. The cost of chang- it were paid or incurred to operate an ex-
quire certain tangible property for use in a ing from one heating system to another is a isting trade or business.
trade or business instead of treating this capital expense and not a deductible one.
amount as a capital expense. The maximum 2) It must be paid or incurred by you before
amount you can deduct is $17,500. See Sec- you actually begin business operations.
tion 179 Deduction in chapter 12.
Depreciation is discussed in chapter 12. Business Assets If you buy business assets. The costs
connected with acquiring a business asset
Amortization and depletion are covered in
A business usually owns property that it become part of your basis in the asset. For
chapter 13. uses, directly or indirectly, to earn its income. example, a lawyer’s fee for negotiating a
If you do not completely recover a capital Property that is used in this way is a business
expense through depreciation, amortization, lease becomes part of your basis in the
asset. Business assets are classified as tan- lease. The cost of a land survey for real es-
or depletion, you can usually recover the bal- gible or intangible, real or personal. tate you plan to buy becomes a part of your
ance when you sell or otherwise give up All the costs of getting a business asset basis in the property once you acquire it.
ownership of your business assets. Basis is that is ordinarily used for more than one year If your attempt to acquire a business as-
subtracted from the amount you realize on a are capital expenses. This includes the cost set is not successful, you can deduct, as a
sale to figure gain or loss (see chapter 21). of freight, installation, and testing. It also in- capital loss, the costs you had in the attempt.
Basis is also the starting point for figuring cludes the costs of building an asset your- You can take this loss whether or not you
gain or loss if a business asset is stolen or self. See chapter 5. eventually go into business.
destroyed (see chapter 25). If you abandon
the asset, you also use basis to figure your Tangible and intangible property. A busi- If you go into business. When you go into
loss. See Dispositions in Publication 946. ness asset may be tangible property—such business, treat all costs you had to get it
as a warehouse, lathe, desk, truck, or tool— started as capital expenses. They are part of
Replacements. Like the cost of improve- or it may be intangible property—such as a your basis in the business. You generally re-
ments, you may not deduct the cost of a re- trademark, customer list, franchise, promis- cover costs for particular assets through de-
placement that stops deterioration and adds sory note, or goodwill. Tangible property is preciation deductions. You generally cannot
to the life of your property. Capitalize and de- property that can be felt or touched. Its phys- recover other expenses until you sell or oth-
preciate it. ical features are what make it useful to you. erwise go out of business.
Treat amounts you pay to replace parts Intangible property is property that is not tan- However, you can choose to amortize
of a machine that only keep it in a normal op- gible. Documents that are merely represen- certain costs you have in setting up your bus-
erating condition like repairs. Deduct them tations of value (such as stock certificates) iness. These costs are deducted as ex-
as business expenses. However, if your or evidence of rights (such as patents) are penses in equal amounts over a period of 60
equipment has a major overhaul, capitalize intangible property. months or more. The costs you can amortize
and depreciate the expense. include:
Real and personal property. Tangible bus-
Capital expenses or deductible ex- 1) Business start-up costs,
iness assets are further classified as either
penses. To help you distinguish between real or personal property. Real property is 2) Organizational costs for a corporation,
capital expenses and deductible expenses, land and anything fixed to the land—for ex- 3) Organizational costs for a partnership,
several different items are discussed below. ample, fences, parking lots, buildings, or and
Business motor vehicles. You usually trees. Everything else is personal property—
capitalize the cost of a motor vehicle you buy for example, furniture, office equipment, ve- 4) The cost of acquiring a lease.
to use in your business. You can recover its hicles, and supplies. Components of build-
cost through annual deductions for ings—such as air conditioning, plumbing, See chapter 13 for more information on busi-
depreciation. and furnaces—may be real or personal prop- ness start-up costs and organizational costs
There are dollar limits on the deprecia- erty, depending on state law. of a corporation or partnership. See chapter
tion you may claim each year for passenger 11 for more information on amortizing the
automobiles used in your business. See cost of a lease.
chapter 12.
Repairs you make to your business vehi- Going Into Business If you do not go into business. If your at-
cle are deductible expenses. However, tempt to go into business is not successful,
When you get ready to go into business, you
amounts you pay to recondition and over- the expenses you had in trying to establish
probably will have a number of different
haul business vehicles are capital expenses. yourself in business fall into two categories:
costs. For example, you may:
Roads and driveways. The cost of 1) The costs you had before making a de-
1) Travel to line up customers and
building a private road on your business cision to acquire or begin a specific bus-
suppliers,
property and the cost of replacing a gravel iness. These costs are personal and
driveway with a concrete one are capital ex- 2) Conduct market surveys, or begin to ad- nondeductible. They include any costs
penses you may be able to depreciate. The vertise your business, incurred in the course of a general
Chapter 4 CAPITAL EXPENSES Page 15
search for, or a preliminary investigation NOTE. For individuals, partners, benefi- business that are the experimental or labora-
of, a business or investment possibility. ciaries, and S corporation shareholders, all tory portion of research and development
2) The costs you had in your attempt to ac- the costs listed above, except carrying costs. This includes all costs incident to the
quire or begin a specific business. charges and costs of removing architectural development or improvement of a product.
These costs are capital expenses and and transportation barriers to disabled and (See Product, later.) It also includes the
can be deducted as a capital loss. elderly people, are adjustments or tax pref- costs of obtaining a patent (i.e., attorneys’
erence items. These items are subject to the fees in making and perfecting a patent
The costs of any assets acquired during alternative minimum tax if they are deducted application).
your unsuccessful attempt to go into busi- on your tax return. Costs qualify as research or experimen-
ness are a part of your basis in the assets. If you decide to deduct these items over tal costs depending on the nature of the ac-
You cannot take a deduction for these costs. an optional write-off period, they are not tivity the costs relates to, rather than the na-
Your costs in these assets will be recovered treated as adjustments or tax preference ture of the product or the improvement being
when you dispose of them. items. For more information, see Optional developed or the level of technological ad-
Write-Off for Certain Expenditures in the in- vancement represented.
structions for Form 6251. Costs are the experimental or laboratory
portion of research and development costs if
Costs You Can Deduct Carrying charges. Carrying charges are the they are for activities intended to discover in-
formation that would eliminate uncertainty
or Capitalize taxes and interest you pay to carry or de-
velop real property or to carry, transport, and concerning the development or improve-
There are certain costs that you can choose install personal property. Certain carrying ment of a product. Uncertainty exists if the
either to deduct or to capitalize. The choice information available to you does not estab-
charges must be capitalized under the uni-
you make depends on when it is best for you lish the capability or method for developing
form capitalization rules. (For more informa-
to recover your costs. or improving the product or the appropriate
tion, see chapter 5.) In addition, you can
If you deduct a cost as an expense, you design of the product.
choose to capitalize carrying charges not
‘‘recover’’ it in full by subtracting it from your Research and experimental costs do not
subject to the uniform capitalization rules,
income. include expenses for:
but only if they are otherwise deductible.
If you capitalize a cost, you may be able 1) Quality control testing,
You can make a separate choice to capi-
to recover the cost through a section 179 de-
talize carrying charges for each project you 2) Efficiency surveys,
duction, a deduction for clean-fuel vehicles
have and for each type of carrying charge.
or certain refueling property, or periodic de- 3) Management studies,
For unimproved and unproductive real prop-
ductions for depreciation, amortization, or 4) Consumer surveys,
erty, your choice is good for only one year.
depletion.
You must make a new choice each year the 5) Advertising or promotions,
For a discussion on the section 179 de-
property remains unimproved and unproduc-
duction and depreciation, see chapter 12; for 6) The acquisition of another’s patent,
tive. For other property, your choice to capi-
a discussion on amortization and depletion, model, production or process, or
talize carrying charges remains in effect until
see chapter 13; for a discussion on the de-
construction, development, or installation is 7) Research in connection with literary,
duction for clean-fuel vehicles and certain
completed (or, for personal property, the historical, or similar projects.
refueling property, see chapter 15 in Publica-
date you first use it, if later).
tion 535.
Or you may recover the cost when you How to make the choice. To make the Product. The term ‘‘product’’ includes:
sell the asset you bought and figure your choice to capitalize a carrying charge, write a 1) Any pilot model,
gain or loss. statement saying which charges you choose
to capitalize. Attach it to your original tax re- 2) Process,
See Publication 551, Basis of Assets for
a discussion of the uniform capitalization turn for the year the choice is to be effective. 3) Formula,
rules that apply to property produced for sale 4) Invention,
or use in a trade or business. Research and experimental costs. The
costs of research and experimentation are 5) Technique,
The costs that you can choose to deduct
or to capitalize include: generally capital expenses. However, you 6) Patent, or
can choose to deduct these costs as current 7) Similar property.
● Certain carrying charges on property (un-
business expenses.
less the uniform capitalization rules apply),
The choice you make applies to all your It also includes products used by you in your
● Research and experimental costs, research and experimental costs. You can- trade or business or held for sale, lease, or
● ‘‘Intangible’’ drilling and development not choose to deduct some of these ex- license.
costs for oil, gas, and geothermal wells, penses and capitalize others. How to make the choice. To choose to
● Exploration costs for new mineral However, if you do not choose to deduct deduct research and experimental costs cur-
deposits, your research and experimental costs cur- rently, claim them as an expense deduction
rently, you have other choices. You can on your income tax return for the year in
● Mine development costs for a new mineral choose to treat them as deferred expenses
deposit, which you first have them.
and amortize them over a period of at least If you want to make this choice after the
● Costs of increasing the circulation of a 60 months, beginning with the month that first year, you must get the permission of the
newspaper or a periodical, and you first receive an economic benefit from Internal Revenue Service (IRS). File Form
● Costs of removing architectural and trans- the research. See Research and Experimen- 3115.
portation barriers to individuals with disa- tal Costs in chapter 13. You can also choose Research credit. You may qualify for a
bilities and the elderly. to deduct them over the 10-year period be- credit on some or all of your research and
ginning with the tax year they were paid or in- experimental costs no matter how you treat
The decision to capitalize or to deduct curred. See Optional Write-Off for Certain them. You must reduce the amount you de-
costs belongs to the business entity, that is, Expenditures in the instructions for Form duct or capitalize by the amount of the credit,
the sole proprietor, partnership, corporation, 6251 and Internal Revenue Code Section unless you choose to take a reduced credit.
estate, or trust. Individual partners, share- 59(e). See the instructions for Form 6765.
holders, and beneficiaries do not make the Research and experimental costs de- The research credit does not apply to
choice themselves (except for exploration fined. Research and development costs are amounts paid or incurred after June 30,
costs for a new mineral deposit). reasonable costs you incur in your trade or 1995.
Page 16 Chapter 4 CAPITAL EXPENSES
Caution: At the time this publication was through depletion as the mineral is removed in commercially marketable quantities. De-
being prepared for print, Congress was con- from the ground. However, you can choose velopment costs include those incurred by a
sidering legislation that would extend the re- to deduct the costs of exploration in the contractor on your behalf. They do not in-
search credit. For more information, see United States (except those for oil, gas, and clude costs for depreciable improvements.
Publication 553, Highlights of 1995 Tax geothermal wells) if you paid or incurred You can also choose to deduct your de-
Changes. them before the development stage began. velopment costs over the 10-year period, be-
For more information, see chapter 11 in Pub- ginning with the tax year they were paid or
Drilling and development costs. The lication 535. incurred.
costs of developing oil, gas, or geothermal If you do not choose to deduct your ex- For more information on development
wells are ordinarily capital expenses. They ploration costs currently, you can choose to costs, see chapter 11 in Publication 535.
can usually be recovered through deprecia- deduct them over the 10-year period begin-
tion or depletion. However, you can choose ning with the tax year they were paid or in-
to deduct as current business expenses cer- curred. See Optional Write-Off for Certain Costs of removing barriers to the dis-
tain drilling and development costs for wells Expenditures in the instructions for Form abled and the elderly. The cost of an im-
located in the United States in which you 6251.
hold an operating or working interest. For provement to a business asset is normally a
more information, see chapter 11 in Publica- capital expense. However, you can choose
tion 535. to deduct your expenses for making a facility
Development costs. You can deduct costs or public transportation vehicle, owned or
Exploration costs. If the costs of determin- paid or incurred during the tax year for devel- leased for use in connection with your trade
ing the existence, location, extent, or quality oping a mine or any other natural deposit or business, more accessible and useable by
of any mineral deposit lead to the develop- (other than an oil or gas well) located in the those who are disabled or elderly. For more
ment of a mine, they ordinarily are capital ex- United States if the costs are paid or in- information, see chapter 11 in Publication
penses. You can recover these costs curred after the discovery of ores or minerals 535.
Chapter 4 CAPITAL EXPENSES Page 17
Topics that amount. Do not include that amount in
This chapter discusses: the basis of the property.
5. ● Cost basis
Settlement costs. You can include in the
● Adjusted basis
Basis of Assets ● Other basis
basis of property you purchase the settle-
ment fees and closing costs that are for buy-
ing it. You cannot include the fees and costs
Useful Items that are for getting a loan on the property. (A
You may want to see: fee is for buying property if you would have
had to pay it even if you bought the property
Introduction Publication
for cash.)
Some of the settlement fees or closing
Basis is the amount of your investment in □ 378 Fuel Tax Credits and Refunds costs that you can include in the basis of
property for tax purposes. Use the basis of
property to figure gain or loss from the sale □ 525 Taxable and Nontaxable Income your property are:
or other disposition of property. Also use it to □ 544 Sales and Other Dispositions 1) Abstract fees (sometimes called ab-
figure the deduction for depreciation, amorti- of Assets stract of title fees),
zation, depletion, and casualty losses. □ 551 Basis of Assets 2) Charges for installing utility services,
This chapter is divided into three
sections: □ 908 Tax Information on Bankruptcy 3) Legal fees (including title search and
□ 917 Business Use of a Car preparing the sales contract and deed),
● Cost Basis,
4) Recording fees,
● Adjusted Basis, and Form (and Instructions)
5) Surveys,
● Other Basis. □ 8594 Asset Acquisition Statement
6) Transfer taxes,
The basis for inventories is discussed in 7) Title insurance, and
chapter 7.
The basis of property you buy is its cost.
Cost Basis 8) Any amounts the seller owes that you
agree to pay, such as back taxes or in-
If you use the asset in a trade or business or The basis of property you buy is usually its terest, recording or mortgage fees,
any other activity conducted for profit, capi- cost. The cost is the amount you pay in cash charges for improvements or repairs,
talize (add to basis) many direct and indirect or in other property or debt obligations. Your and sales commissions.
costs. cost includes amounts you pay for:
Your original basis in property is adjusted 1) Sales tax charged on the purchase, You must reasonably allocate these fees or
(increased or decreased) for certain events. costs between land and improvements, such
2) Freight charges to obtain the property,
If you make improvements to the property, as buildings, to figure the basis for deprecia-
increase your basis. If you take deductions 3) Installation and testing, tion of the improvements. Allocate the fees
for depreciation or casualty losses, reduce 4) Excise taxes, according to the fair market values of the
your basis. land and improvements at the time of
5) Legal and accounting fees (when they
You cannot determine your basis in some purchase.
must be capitalized),
assets by cost. This includes property you S e t t l e m e n t c o s t s do not include
receive as a gift or inheritance. It also applies 6) Revenue stamps, amounts placed in escrow for the future pay-
to property received in an involuntary ex- 7) Recording fees, and ment of items such as taxes and insurance.
change and certain other circumstances. If Some settlement fees and closing costs
you acquire property by inheritance, receive 8) Real estate taxes (if assumed for the
you cannot include in the basis of the prop-
a gift of property, or have property trans- seller).
erty are:
ferred to you from a spouse or former
In addition, the basis of real estate and busi- 1) Fire insurance premiums.
spouse, see Other Basis in Publication 551.
If you sell or exchange your property, fig- ness assets may include other items. 2) Rent for occupancy of the property
ure your gain or loss on the transaction. before closing.
Compare the amount realized from the sale Loans with low or no interest. If you buy
business or investment property on any 3) Charges for utilities or other services re-
or exchange to the adjusted basis of the
time-payment plan that charges little or no lating to occupancy of the property
property you transferred. The amount real-
interest, the basis of your property is your before closing.
ized is the money you received plus the fair
market value of any other property you re- stated purchase price less the amount con- 4) Fees for refinancing a mortgage.
ceived. For information on sales and ex- sidered to be unstated interest. You gener-
ally have unstated interest if your interest 5) Charges connected with getting a loan,
changes, see chapter 21. such as:
To figure depreciation, use ‘‘unadjusted rate is less than the applicable federal rate.
basis.’’ For information on depreciation, see See Unstated Interest in chapter 24. a) Points (discount points, loan origina-
chapter 12. tion fees),
As a partner, you must know the basis of Real Property b) Mortgage insurance premiums,
your interest in the partnership to figure your If you buy real property, certain fees and
allowable deduction for partnership losses. c) Loan assumption fees,
other expenses you pay are part of your ba-
You also must know your basis if you dis- sis in the property. d) Cost of a credit report, and
pose of all or part of your interest in the part-
e) Fees for an appraisal required by a
nership. For information on partnerships, Real estate taxes. If you buy real property lender.
see chapter 28. and agree to pay certain taxes the seller
If any of your debts were canceled by a owed on it, treat the taxes you pay as part of 6) Fees for refinancing a mortgage.
creditor, or were discharged because you your basis. You cannot deduct them as taxes
became bankrupt, the basis of your assets paid.
might be affected. For more information, see If you reimburse the seller for taxes the Points. If you pay points to obtain a loan (in-
Publication 908. seller paid for you, you can usually deduct cluding a mortgage, second mortgage, line
Page 18 Chapter 5 BASIS OF ASSETS
of credit, or a home equity loan), you gener- Business Assets 4) Research and developmental expenses
ally must capitalize and amortize them rata- allowable as a deduction under section
If you purchase property to use in your busi-
bly over the term of the loan. Do not add the 174 of the Internal Revenue Code.
ness, your basis usually is its actual cost to
cost to the basis of the related property. 5) Costs for personal property acquired for
you. However, if you construct, build, or oth-
Points on home mortgage. Special resale if your (or your predecessor’s) av-
erwise produce property, you may be subject
rules may apply to the amounts you and the erage annual gross receipts do not ex-
to the uniform capitalization rules (discussed
seller pay as points when you obtain a mort- ceed $10 million.
later) to determine the basis of the property.
gage to purchase your main home. If these
amounts meet certain requirements, you can Example 1. Dale White is an indepen-
dent contractor. He purchased a building for More information. For more information on
deduct them in full as points for the year in
his business. He used it to store his con- the uniform capitalization rules, see the reg-
which they are paid. If you deduct seller-paid
struction equipment. His basis in the building ulations under section 263A of the Internal
points, reduce your basis by that amount.
is its cost to him. Revenue Code.
For more information, see Points in Publica-
tion 936, Home Mortgage Interest Example 2. Assume the same facts as in
Deduction. Example 1 except, instead of purchasing the Intangible Assets
building, Dale had his employees construct Intangible assets include goodwill, patents,
Assumption of a mortgage. If you buy the building. He must determine his basis in copyrights, trademarks, trade names, and
property and assume an existing mortgage the building under the uniform capitalization franchises. The basis of an intangible asset
on the property, your basis includes the rules. is usually its cost. If you acquire multiple as-
amount you pay for the property plus the sets, for example a going business for a
amount to be paid on the mortgage you Uniform Capitalization Rules lump-sum, see Allocating the Basis, later, to
assume. The uniform capitalization rules specify the figure the basis of the individual assets.
costs you add to basis in certain
Example. If you buy a building and make circumstances. Patents. The basis of a patent you get for
a down payment for $20,000 and assume a your invention is the cost of development,
mortgage of $80,000 on it, your basis is Who must use. You must use the uniform such as research and experimental expendi-
$100,000. capitalization rules if you: tures, drawings, working models, and attor-
1) Produce real property or tangible per- neys’ and governmental fees. If you deduct
Constructing nonbusiness assets. If you sonal property for use in a trade or busi- the research and experimental expenditures
build nonbusiness property (i.e., a home), or ness or an activity engaged in for profit, as current business expenses, you cannot
have assets built for you, the expenses you include them in the basis of the patent. The
pay for this construction are part of your cost 2) Produce real property or tangible per- value of your time spent on an invention is
basis. Some of these expenses include: sonal property for sale to customers, or not part of the basis.
3) Acquire property for resale.
1) Land,
Copyrights. If you are an author, the basis
2) Materials and supplies, You produce property if you construct, build, of the copyright for your work usually will be
install, manufacture, develop, improve, cre- your cost of getting the copyright, plus copy-
3) Architect’s fees, ate, raise, or grow the property. Treat prop- right fees, attorneys’ fees, clerical assis-
erty produced for you under a contract as tance, and the cost of plates that remain in
4) Building permits, produced by you up to the amount you pay or your possession. Do not include in the basis
5) Payments to contractors, otherwise incur for the property. Tangible the value of your time as the author, or any
personal property includes films, sound re- other person’s time you did not pay for.
6) Payments for rental equipment, and cordings, video tapes, books, art work, or
similar property. Franchises, trademarks, and trade
7) Inspection fees. Under the uniform capitalization rules, names. If you buy a franchise, trademark, or
you capitalize direct costs and an allocable trade name, the basis is its cost, unless you
In addition, if you own a business and use part of most indirect costs incurred due to can deduct your payments as a business
your employees, material, and equipment to production or resale activities. You must in- expense.
construct a nonbusiness asset, your basis clude certain expenses you have during the
would also include: year in the basis of property you produce or
in your inventory costs, rather than deduct Allocating the Basis
1) Employee compensation paid for the them as a current expense. You will recover If you buy multiple assets for a lump sum, al-
construction work, these costs through depreciation, amortiza- locate the amount you pay to each of the as-
tion, or cost of goods sold when you use, sets you receive. Make this allocation to fig-
2) Depreciation deductions on equipment
sell, or otherwise dispose of the property. ure your basis for depreciation and gain or
you own while it is used in the
Any cost that you could not use to figure loss on a later disposition of any of these as-
construction,
your taxable income for any tax year is not sets. See Trade or business acquired, later.
3) Operating and maintenance costs for subject to the uniform capitalization rules.
equipment used in the construction, and Group of assets acquired. If you buy multi-
Exceptions. The uniform capitalization ple assets for a lump sum, you and the seller
4) The cost of business supplies and rules do not apply to certain property. This may agree to a specific allocation of the
materials consumed in the construction. includes: purchase price to each asset in the sales
contract. If this allocation is based on the
1) Property you produce that you do not
Do not deduct these expenses which you value of each asset, and the sale is an arm’s-
use in your trade or business, or activity
must capitalize (include in the asset’s basis). length transaction, the allocation generally
conducted for profit.
Also, reduce your basis by any jobs credit, will be accepted. However, see Trade or
Indian employment credit, or empowerment 2) Costs paid or incurred by an individual business acquired, next.
zone employment credit allowable on the (other than as an employee) or a quali-
wages you pay in (1). Do not include the fied employee-owner of a corporation Trade or business acquired. If you acquire
value of your own labor, or any other labor who is a writer, photographer, or artist. a group of assets that is a trade or business,
you did not pay for, in the basis of any prop- 3) Property you produce under a long-term allocate the purchase price to the various as-
erty you construct. contract. sets acquired.
Chapter 5 BASIS OF ASSETS Page 19
Make the allocation among the assets in Subdivided lots. If you buy a tract of land Rehabilitation expenses also increase
proportion to (but not in excess of) their fair and subdivide it, allocate the basis to the in- basis. However, you must subtract any reha-
market value on the purchase date in the fol- dividual lots based on the fair market value bilitation credit allowed for those expenses
lowing order: of each lot to the total price paid for the tract. before you add them to your basis. If you
This allocation is necessary because you have to recapture any of the credit, increase
1) Cash, demand deposits, and similar must figure the gain or loss on the sale of your basis by the amount of the recapture.
accounts, each individual lot. As a result, you do not re- If you make additions or improvements to
2) Certificates of deposit, U.S. Govern- cover your entire cost in the tract until you business property, keep separate accounts
ment securities, readily marketable have sold all of the lots. for them. Also, depreciate the basis of each
stock or securities, and foreign Future development costs. Certain according to the depreciation rules in effect
currency, procedures explain how to get permission to when you place the addition or improvement
add to the basis of each lot the estimated fu- in service. For more information, see chapter
3) All other assets except section 197 in- ture cost of qualified development 12.
tangibles, and expenses. Some items added to the basis of prop-
4) Section 197 intangibles. For sales you made after December erty are:
31,1992, of lots on which development work
1) The cost of extending utility service
is not complete, see Revenue Procedure
Agreement. If you and the seller agree in lines to the property,
92–29. However, if you received explicit con-
writing to allocate the consideration, or the sent from the IRS to use Revenue Proce- 2) Legal fees, such as the cost of defend-
fair market value of any asset, the agree- dure 75–25 (amplified in Revenue Procedure ing and perfecting title,
ment is binding on both you and the seller 78–25), you can continue to use this revenue
unless the IRS determines that the amounts 3) Legal fees for obtaining a decrease in
procedure for sales of lots covered by the an assessment levied against property
are not appropriate. consent, including sales occurring after De- to pay for local improvements,
Reporting requirement. Both the buyer cember 31, 1992.
and seller of a trade or business must report Use of erroneous cost basis. If you 4) Zoning costs, and
to the IRS the allocation of the sales price made a mistake in figuring the cost basis of 5) The capitalized value of a redeemable
among section 197 intangibles and the other subdivided lots that you sold in previous ground rent.
business assets. Use Form 8594 to provide years, you cannot correct the mistake for
this information. The buyer and seller should years for which the statute of limitations has Assessments for local improvements.
each attach Form 8594 to their federal in- expired. Figure the cost basis of any remain- Add assessments for items such as streets
come tax returns for the year in which the ing lots by allocating the original cost basis and sidewalks, which increase the value of
sale occurred. of the entire tract among the original lots. the property assessed, to the basis of the
Example. You bought a tract of land to property. Do not deduct them as taxes. How-
Land and buildings. If you buy buildings which you assigned a cost of $15,000. You ever, you can deduct assessments for main-
and the land on which they stand for your subdivided the land into 15 building lots of tenance or repair or for meeting interest
business and you pay a lump sum, allocate equal size and equitably divided your basis charges on the improvements as taxes.
the basis of the whole property among the so that each lot had a basis of $1,000. You
land and the buildings so you can figure the treated the sale of each lot as a separate
depreciation allowable on the building. See transaction and figured gain or loss sepa-
Decreases to Basis
chapter 12. rately on each sale. Some items that reduce the basis of your
When you allocate the basis between Several years later you determine that property are:
land and buildings or among the lots, the your original basis in the tract was $22,500 1) The section 179 deduction,
amount used as the basis of each asset is and not $15,000. You sold 8 lots using
2) The deduction for clean-fuel vehicles
the ratio of the fair market value of that asset $8,000 of basis in years for which the statute
and clean-fuel vehicle refueling
to the fair market value of the whole property of limitations has expired. You now can take
property,
at the time you get it. If you are not certain of $1,500 of basis into account for figuring gain
the fair market values of land and buildings, or loss only on the sale of each of the re- 3) Nontaxable corporate distributions,
you can allocate the basis among them maining 7 lots ($22,500 basis divided among 4) Deductions previously allowed (or al-
based on their assessed values for real es- all 15 lots). You cannot refigure (to $1,500) lowable) for amortization, depreciation,
tate tax purposes. the basis of the 8 lots sold in tax years barred and depletion,
Demolition of building. Add demolition by the statute of limitations.
5) Exclusion from income of subsidies for
costs and other losses incurred for the dem-
energy conservation measures,
olition of any building to the basis of the land
6) Credit for qualified electric vehicles,
on which the demolished building was lo-
cated. Do not claim it as a current deduction.
Adjusted Basis
7) Gain from the sale of your old home on
Modification of building. A modifica- Before figuring any gain or loss on a sale, ex- which tax was postponed,
tion of a building will not be treated as a change, or other disposition of property or
figuring allowable depreciation, depletion, or 8) Investment credit (part or all of credit)
demolition if:
amortization, you must usually make certain taken,
1) 75 percent or more of the existing exter- adjustments (increases and decreases) to 9) Casualty and theft losses,
nal walls of the building are retained in the basis of the property. The result of these
place as internal or external walls, and 10) Certain cancelled debt excluded from
adjustments to the basis is the adjusted
income,
2) 75 percent or more of the existing inter- basis.
nal structural framework of the building 11) Rebates received from the manufac-
turer or seller,
is retained in place. Increases to Basis
Increase the basis of any property by all 12) Easements,
If the building is a certified historic items properly added to a capital account. 13) Residential energy credit,
structure the modification must be part of a This includes the cost of any improvements
certified rehabilitation. If these conditions 14) Gas-guzzler tax, and
having a useful life of more than one year
are met, add the costs of the modifications and amounts spent after a casualty to re- 15) Tax credit or refund for buying a diesel-
to the basis of the building. store the damaged property. powered highway vehicle.
Page 20 Chapter 5 BASIS OF ASSETS
Table 6-1. Examples of Increases and Decreases to Basis In decreasing your basis for depreciation,
take into account the amount deducted on
your tax returns as depreciation expense,
Increases to Basis Decreases to Basis
and any depreciation you must capitalize
Capital improvements: Exclusion from income of subsidies for under the uniform capitalization rules.
Putting an addition on your home energy conservation measures
Replacing an entire roof
Paving your driveway Casualty or theft loss Canceled Debt Excluded from
Installing central air conditioning Income
Rewiring your home Credit for qualified electric vehicles If a debt is canceled or forgiven, other than
as a gift or bequest, the debtor generally
Assessments for local improvements: Gain from the sale of your old home on must include the canceled amount in gross
Water connections which tax was postponed income for tax purposes. A debt includes any
Sidewalks indebtedness for which the debtor is liable or
Roads Section 179 deduction which attaches to property the debtor holds.
You can exclude your canceled debt
Casualty Losses: Deduction for clean-fuel vehicles and
from income if the debt is:
Restoring damaged property clean-fuel vehicle refueling property
1) Canceled in a title 11 bankruptcy case
Legal fees: Depreciation or when you are insolvent,
Such as the cost of defending and
2) Qualified farm debt, or
perfecting a title Nontaxable corporate distributions
3) Qualified real property business indebt-
Zoning costs edness (provided you are not a C
corporation).
Some of these decreases to basis are dis- vehicles or clean-fuel vehicle refueling prop- If you exclude canceled debt from income,
cussed next. erty, or both, you must decrease the basis of you may have to reduce the basis of your
the property by the amount of the deduction. property.
Section 179 deduction. If you take the sec- For more information on these deductions, For more information on canceled debt in
tion 179 deduction for all or part of the cost see chapter 15 in Publication 535. a bankruptcy case or during insolvency, see
of business property, decrease the basis of Publication 908. For more information on
the property by the deduction. For more in- Exclusion from income of subsidies for canceled debt that is qualified farm debt, see
formation, see chapter 12. energy conservation measures. If you re- chapter 4 in Publication 225.
ceived a subsidy from a public utility com-
Casualties and thefts. If you have a casu- pany for the purchase or installation of any Adjusted Basis Example
alty or theft loss, decrease the basis of your energy conservation measure, you can ex- In January 1990, you paid $80,000 for real
property by the amount of any insurance or clude it from income. Reduce the basis of property to be used as a factory. You also
other reimbursement you receive and by any the property on which you received the sub- paid commissions of $2,000 and title search
deductible loss not covered by insurance. sidy by the excluded amount. For more infor- and legal fees of $600. You allocated the to-
However, increase your basis for amounts mation on this subsidy, see Publication 525. tal cost of $82,600 between the land and the
you spend after a casualty to restore the building—$10,325 for the land and $72,275
damaged property. For more information, Gas-guzzler tax. Decrease the basis in your for the building. Immediately, you spent
see chapter 25. car by the gas-guzzler (fuel economy) tax if $20,000 in remodeling the building before
you begin using the car within 1 year of the you placed it in service. You were allowed
Easements. The amount you receive for date of its first sale for ultimate use. This rule depreciation of $14,526 for the years 1990
granting an easement is usually considered also applies to someone who later buys the through 1994. In 1993 you had a casualty
to be from the sale of an interest in your real car and begins using it not more than 1 year loss that was not covered by insurance of
property. It reduces the basis of the affected after the original sale for ultimate use. If the $5,000 on the building from a fire. This loss
part of the property. If the amount received is car is imported, the one-year period begins was claimed as a deduction. You spent
more than the basis of the part of the prop- on the date of entry or withdrawal of the car $5,500 to repair the fire damages. The ad-
erty affected by the easement, reduce your from the warehouse if that date is later than justed basis of the building on January 1,
basis to zero and treat the excess as a rec- the date of the first sale for ultimate use. 1995, is figured as follows:
ognized gain. See Easements in chapter 21.
Building
Depreciation. Decrease the basis of your
Diesel-powered vehicle. If you received an property by the amount of depreciation you Original cost of building,
income tax credit or refund for buying a die- could have deducted on your tax returns including fees and
sel-powered highway vehicle, reduce your under the method of depreciation you se- commissions . . . . . . . . . . . . . . $72,275
basis in that vehicle by the credit or refund lected. If you took less depreciation than you Adjustments to basis:
allowable. For more information about this could have under the method you selected, Add: . . . . . . . . . . . . . . . . . . . . . . . . . .
credit or refund, see Publication 378. decrease the basis by the amount you could Improvements . . . . . . . . 20,000
have taken under that method. If you did not Repair of fire damage 5,500
Credit for qualified electric vehicle. If you take a depreciation deduction, then make $97,775
claim the credit for qualified electric vehicles, adjustments to basis for depreciation you Subtract:
you must reduce the basis of the property on could have taken. Depreciation . . . . . . . . . . $14,526
which you claimed the credit. For more infor- If you deducted more depreciation than Casualty loss . . . . . . . . . 5,000 19,526
mation on this credit, see chapter 15 in Publi- you should have, decrease your basis as fol- Adjusted basis on January 1, 1995 $78,249
cation 535. lows. Decrease it by an amount equal to the
depreciation you should have deducted as The basis of the land, $10,325, remains
Deduction for clean-fuel vehicles and well as by the part of the excess depreciation unchanged. It is not affected by any of the
clean-fuel vehicle refueling property. If you deducted that actually reduced your tax above adjustments, which affect only the
you take either the deduction for clean-fuel liability for any year. basis of the building.
Chapter 5 BASIS OF ASSETS Page 21
Not similar or related property. If you re- Exchange expenses. Exchange expenses
Other Basis ceive money or other property that is not
similar or related in service or use to the old
are generally the closing costs that you pay.
They include such items as brokerage com-
There are many times when you cannot use property, and you buy new property that is missions, attorney fees, deed preparation
cost as basis. In these cases, the fair market similar or related in service or use to the old fees, etc. Add them to the basis of the like-
value or the adjusted basis of certain prop- property, the basis of the new property is the kind property received.
erty may be used. cost of the new property decreased by the
amount of gain that is not recognized on the Property plus cash. If you trade property in
Fair market value (FMV). FMV is the price exchange. a nontaxable exchange and pay money, the
at which the property would change hands basis of the property you receive is the basis
Example. The state condemned your
between a buyer and a seller, neither having of the property you exchanged increased by
property. The property had an adjusted basis
to buy or sell, and both having reasonable the money you paid.
of $26,000, and the state paid you $31,000
knowledge of all necessary facts. Sales of for it. You realized a gain of $5,000 ($31,000 Example. You trade in a truck (adjusted
similar property, on or about the same date, – $26,000). You bought new property that is basis $3,000) for another truck (FMV
may be helpful in figuring the property’s similar in use to the old property for $29,000. $7,500) and pay $4,000. Your basis in the
FMV. You recognize a gain of $2,000 ($31,000 – new truck is $7,000 (the $3,000 basis of the
$29,000), the unspent part of the payment old truck plus the $4,000 paid).
Property for services. If you receive prop- from the state. The basis of the new property
erty for services, include the property’s FMV is figured as follows: Special rules for related persons. If a like-
in income. The amount you include in in- kind exchange is made directly or indirectly
come becomes your basis. If the services Cost of new property . . . . . . . . . . . . . . . . . . . $29,000 between related persons and either party
were performed for a price agreed on before Minus: Gain not recognized . . . . . . . . . . . . 3,000 disposes of the property within 2 years after
hand, it will be accepted as the FMV of the Basis of the new property . . . . . . . . . . . . . . $26,000 the exchange, the exchange is disqualified
property if there is no evidence to the from like-kind exchange treatment. Each
contrary. person must report any gain or loss not rec-
Restricted property. If you receive ognized on the original exchange. Each per-
Allocating the basis. If you buy more than
property for services and the property is sub- son reports it on the tax return filed for the
one piece of replacement property, allocate
ject to certain restrictions, your basis in the year in which the later disposition occurred.
your basis among the properties based on If this special rule applies, the basis in the
property is its FMV when it becomes sub-
their respective costs. property received in the original exchange
stantially vested. Property becomes sub-
stantially vested when you can transfer it or it Example. If, in the previous example, the will be its fair market value.
is not subject to a substantial risk of forfei- state had condemned unimproved real prop- These rules generally do not apply to dis-
ture. For more information on restricted erty, and the new property you bought was positions due to:
property, see the discussion on Restricted improved real property with both land and 1) The death of either related person,
Property Received for Services in Publica- buildings, make an allocation. Take the new
property’s $26,000 basis and allocate it be- 2) Involuntary conversions, or
tion 525.
tween land and buildings based on their 3) Exchanges whose main purpose is not
Taxable exchanges. A taxable exchange is costs. the avoidance of federal income tax.
an exchange on which the gain is taxable or See chapter 25 for more information on
the loss is deductible. If you receive property the involuntary exchange rules. Related persons. Generally, related
in exchange for other property in a taxable persons are ancestors, lineal descendants,
brothers and sisters (whole or half), and a
exchange, the basis of the property you re- Nontaxable Exchanges spouse.
ceive is usually its FMV at the time of the A nontaxable exchange is an exchange in
exchange. For other ‘‘related persons’’ (i.e., two or
which any gain is not taxed and any loss can- more corporations, an individual and a cor-
not be deducted. If you receive property in a poration, a grantor and fiduciary, etc.) see
Involuntary Exchanges nontaxable exchange, its basis is usually the the rules relating to losses under Sales and
If you acquire property as a result of an invol- same as the basis of the property you Exchanges Between Related Parties in
untary exchange such as a casualty, theft, or exchanged. chapter 22.
condemnation, you can figure the basis of
the replacement property using the basis of Like-Kind Exchanges Exchange of businesses. Exchanging the
the property exchanged. See chapter 25. The exchange of property for the same kind assets of one business for the assets of an-
of property is the most common type of non- other business is a multiple asset exchange.
Similar or related property. If you receive taxable exchange. For information on determining basis in a
property that is similar or related in service or To qualify as a like-kind exchange, both multiple asset exchange, see Multiple Prop-
use to the property exchanged, the new the property you exchange and the property erty Exchanges, in Publication 544.
property’s basis is the same as the old you receive must be held by you for business
property’s basis on the date of the exchange or investment purposes. There must be an Partially nontaxable exchange. A partially
with the following adjustments: exchange of like-kind property (depreciable nontaxable exchange is an exchange in
tangible personal property may be like-class which you receive unlike property or money
1) Decreased by—
property). For other requirements, see Like- in addition to like property. The basis of the
a) Any loss recognized on the ex- kind exchanges, in chapter 21. property you receive is the same as the basis
change, and The basis of the property you receive is of the old property with the following
b) Any money received that was not the same as the basis of property you gave adjustments:
spent on similar property. up. 1) Decreased by—
2) Increased by— Example. You exchange real estate (ad- a) Any money you received, and
justed basis $50,000, FMV $80,000) held for
a) Any gain recognized on the ex- b) Any loss recognized on the
investment for other real estate (FMV
change, and exchange.
$80,000) held for investment. Your basis in
b) Any cost of acquiring replacement the new property is the same as the basis of 2) Increased by—
property. the old ($50,000). a) Any additional costs incurred, and
Page 22 Chapter 5 BASIS OF ASSETS
b) Any gain recognized on the Partial Business Use of Property Use this adjusted basis only for depreciating
exchange. the new property. Do not use it to figure a
If you have property used partly for business gain or loss on the sale of the new property.
and partly for personal use, and you ex-
The other party to the transaction who changed it in a nontaxable exchange for
assumes your liabilities (including a nonre- property to be used wholly or partly in your Property changed to business or rental
course obligation), treats them as money business, the basis of the property you re- use. When you hold property for personal
transferred to you in the exchange. ceive is figured as if you exchanged two use and change it to business use or use it to
Allocate the basis among the properties, properties. The first is an exchange of like- produce rent, you must figure the basis for
other than money, you received in the ex- kind property. The second is personal use depreciation. An example of this would be
change. In making this allocation, the basis property on which gain is recognized and renting out your former main home.
loss is not recognized. Basis for depreciation. The basis for
of the unlike property is its FMV on the date
First, figure your adjusted basis in the depreciation equals the lesser of:
of the exchange. The remainder is the basis
property you transfer as if you transferred
of the like property.
two separate properties. Figure the adjusted
basis of each part of the property by taking 1) The FMV of the property on the date of
Example 1. You exchange a truck (ad- into account any adjustments to basis. De- the change, or
justed basis $6,000) for a new, smaller truck duct the depreciation you took or should
(FMV $5,200) and $1,000. You have a rec- have taken from the adjusted basis of the 2) Your adjusted basis on the date of the
ognized gain of $200 ($6,200 – $6,000). business part. Then figure the amount real- change.
Your basis in the new truck is figured as ized for your property and properly allocate it
follows: to the business and nonbusiness portions of
the property you transferred.
Example. Several years ago you paid
In this case, you exchanged property per-
Adjusted basis of old truck . . . . . . . . . . . . . . . $6,000 $60,000 to have your house built on a lot that
mitted to be exchanged tax free. Recognize
Minus: Cash you received . . . . . . . . . . . . . . . . 1,000 cost you $10,000. Before changing the prop-
any gain from the transaction on your per-
erty to rental use last year, you paid $20,000
$5,000 sonal-use property. The basis of the prop-
erty acquired is the total basis of the proper- for permanent improvements to the house
Plus: Gain recognized . . . . . . . . . . . . . . . . . . . . 200
ties transferred, adjusted to the date of the and claimed a $2,000 casualty loss deduc-
Basis of new truck $5,200 tion for damage to the house. Because land
exchange, increased by the gain recognized
on the other property. You are deemed to is not depreciable, you can only include the
have received in exchange for your other cost of the house when figuring the basis for
Example 2. You had an adjusted basis property an amount equal to its fair market depreciation.
of $15,000 in real estate you held for invest- value on the date of the exchange. Your adjusted basis in the house when
ment. You exchange it for other real estate you change its use is $78,000 ($60,000 +
to be held for investment with a fair market $20,000 – $2,000). On the date of change,
value of $12,500, a truck with a FMV of Listed property. Special rules apply to your property has a FMV of $80,000, of
$3,000, and $1,000. You have a gain of listed property not used 100% in your busi- which $15,000 is for the land and $65,000
$1,500 ($16,500 – $15,000) recognized on ness. Listed property includes: for the house. The basis for depreciation on
the exchange. Your basis in the properties the house is $65,000, the FMV at the date of
Any automobile or other property used the change in use, because it is less than
you received is:
for transportation, your adjusted basis ($78,000).
Sale of property. If you later sell or dis-
Adjusted basis of real estate transferred Property used for entertainment, such as pose of the property, the basis of the prop-
........................................ $15,000 photographic and video recording
erty you use will depend on whether you are
Minus: Cash received . . . . . . . . . . . . . . . . . . . 1,000 equipment,
figuring gain or loss.
$14,000 Gain. The basis for gain is your adjusted
Cellular telephone or similar equipment,
Plus: Gain recognized . . . . . . . . . . . . . . . . . . 1,500 basis when you sell the property.
and
Total basis of properties received $15,500
Computers and related peripheral equip- Example. Assume the same facts as in
ment not used exclusively at a regular the previous example, except that after be-
Allocate the total basis of $15,500 between business location. ing allowed depreciation deductions of
the truck and the real estate. The basis of $37,500 you sell the property at a gain. Your
the truck is its FMV, $3,000, and the basis of adjusted basis in this case would be
Under a special rule, when listed property $160,500 ($178,000+ $20,000 (land) –
the real estate is the remainder, $12,500.
used less than 100% for business is traded $37,500).
for business property, your basis for depre- Loss. Figure the basis for loss using the
ciating the newly acquired property must be smaller of your adjusted basis or the FMV at
Trade-in or sale and purchase. If a sale
adjusted. First, figure the adjusted basis of the time of the change.
and purchase are a single transaction, you
the old property. Add to this adjusted basis
cannot increase the basis of property for de-
any additional amount paid for the new prop-
preciation by selling your old property out- erty. Finally, subtract from that total any re- Example. Assume the same facts as in
right to a dealer and then buying new prop- mainder of: the previous example, except that after be-
erty from the same dealer. If your sale of old ing allowed depreciation deductions of
property and purchase of new property are 1) The depreciation that would have been $37,500 you sell the property at a loss. Your
dependent on each other, you are consid- allowable if the old property had been adjusted basis in this case would be the FMV
ered to have traded in your old property. used 100% for business or investment ($180,000) because it is less than the ad-
Treat the transaction as an exchange no purposes, over justed basis ($198,000) on the date of the
matter how it is carried out. You cannot avoid change. That amount ($180,000) is reduced
this trade-in rule by using a subsidiary in the 2) The depreciation allowed for the old by the depreciation deduction to arrive at a
transaction. property. basis of $142,250 ($180,000– $37,500).
Chapter 5 BASIS OF ASSETS Page 23
Part Three.
Figuring This Part discusses the items that go into figuring the gross profit of your
business—gross receipts and the cost of goods sold. The method for
figuring gross profit is essentially the same whether your business is a sole
Gross Profit proprietorship, a partnership, or a corporation.
you sell your product or services. Interest is year in which the units are credited to your
business income to a lending company. account.
6. Fees are business income to a professional The dollar value of units received for ser-
person. Rents are business income to a per- vices by an employee of the club, who can
Business son in the real estate business. Dividends
generally are business income to a dealer in
use the units in the same manner as other
members, must be included in the employ-
Income securities. All income received by a corpora-
tion is business income regardless of its
ee’s gross income for the tax year in which
received and is wages for social security and
source. Medicare taxes (FICA), federal unemploy-
Example. You work full time as a ment taxes (FUTA), and income tax with-
mechanical engineer for an aircraft manu- holding. See chapter 33.
Introduction facturer. During your nonworking hours, you Example 4. You are a cash method tax-
are an artist. The income you receive from payer. You join a barter club and agree to
You must report on your tax return any in- provide specific services to any member for
come you receive from your trade or busi- the sale of your paintings is business
income. a specified number of hours. Each member
ness or any other source unless it is ex- has access to a directory that lists the mem-
cluded by law. The income can be in the bers of the club and the services available.
form of cash, property, or services. Some Property or Services Members contact each other directly and
types of income are:
(Barter) request services to be performed. You are
1) Interest, dividends, rents, royalties. Bartering is an exchange of property or ser- not required to provide services unless re-
2) Payment for services, including fees, vices. You must include in your income, at quested by another member, but you can
commissions, fringe benefits, and simi- the time received, the fair market value of use as many of the offered services as you
lar items. property or services you receive in bartering. wish without paying a fee.
If you exchange services with another per- You must include the fair market value of
3) Gain from the sale or exchange of prop- any services you receive from club members
erty (see chapter 21). son and you both have agreed ahead of time
as to the value of the services, that value will in your income when you receive them even
4) Income from the discharge of if you have not provided any services to club
be accepted as the fair market value unless
indebtedness. members.
the value can be shown to be otherwise.
5) Distributive shares of partnership gross Example 1. You perform legal services
income (see chapter 28). Rents. If you receive property or services as
for a client, a small corporation. In payment a payment of rent, you must include the fair
for your services, you receive shares of market value of the property or services in
stock in the corporation. You must include your income.
Topics the fair market value of the shares in income.
This chapter discusses: Example. You own an apartment build-
Example 2. Both you and a house ing, and you received a work of art created
● Kinds of income painter are members of a barter club, an or- by an artist in return for the artist’s rent-free
● Items that are not income ganization that each year gives its members use of an apartment for 6 months. The fair
● Accounting for your income a directory of members and the services market value of the art work is included in
each member provides. Members get in your income, and the fair rental value of the
● Prepaid income touch with other members directly and bar- apartment is included in the artist’s gross
gain for the value of the services to be income.
Useful Items performed.
You may want to see: In return for accounting services you pro- Property as dividend. If you receive prop-
vided for the house painter’s business, the erty in exchange for a dividend, include the
Publication house painter painted your home. The fair fair market value of the property in income.
□ 225 Farmer’s Tax Guide market value of the services you received
□ 525 Taxable and Nontaxable Income from the house painter must be included in Information returns. If you are involved in
your income, and the fair market value of a bartering transaction you may be required
□ 550 Investment Income and your accounting services must be included in to file information returns. See chapter 36 for
Expenses the house painter’s income. more details.
□ 908 Tax Information on Bankruptcy Example 3. You are a member of a bar-
□ 1212 List of Original Issue Discount ter club that uses credit units to credit or Rental Income
Instruments debit members’ accounts for goods or ser- The amount you get from the rental of any
vices provided or received. As soon as units property is included in your gross income.
are credited to a member’s account, the For rental property, gross income means
member can use them to buy goods or ser- gross receipts from rents.
Kinds of Income vices or sell or transfer the units to other
This chapter primarily covers income from a members. Prepaid rent. Advance payments received
trade or business (business income). Busi- The value of credit units received must under a lease that does not put any restric-
ness income is income you receive when be included in your gross income for the tax tion on their use or enjoyment are income in
Page 24 Chapter 6 BUSINESS INCOME
the year they are received. This is true no is greater than the face value is called bond Canceled Debt
matter what accounting method or period premium. Bond premium is included in the
The following explains the general rule for in-
you use. corporation’s income, but not all of it is in- cluding canceled debt in income and the ex-
cluded in the year the bonds are issued. Part ceptions to the general rule.
Lease bonus. A bonus that you receive of the premium is included in income in each
from a tenant for granting a lease is an addi- tax year during the term of the bonds.
tion to the rent and included in your rental in- General Rule
To figure how much to include for each
come in the year it is received. Generally, if a debt you owe is canceled or
tax year, divide the number of months the
forgiven, other than as a gift or bequest, you
bonds are outstanding during the year by the must include the canceled amount in your
Lease cancellation payments. Payments number of months from the date of issue to
that you receive from your tenant for cancel- gross income for tax purposes. A debt in-
the date of maturity. Then multiply this an- cludes any indebtedness for which you are li-
ing a lease are reported in gross income in
swer by the total bond premium, less any able or which attaches to property you hold.
the year received.
conversion feature. For purposes of deter- Example. You obtained a mortgage loan
mining premium, other interest-bearing obli- on your home several years ago at a rela-
Payments to third parties. If your tenant
gations issued by corporations, such as de- tively low rate of interest. This year, in return
makes payments to someone else under an
bentures, notes, and certificates, are treated for your paying off the loan early, the lending
agreement to pay your debts or obligations,
the payments are included in your rental in- the same way. institution cancels part of the remaining prin-
come when the tenant makes the payments. Original issue discount (OID). If a bond cipal. You must include the amount canceled
A common example of this kind of income is is issued for a lower price than the amount in gross income.
a tenant’s payment of the landlord’s prop- the issuer will pay when the bond matures,
erty taxes on leased real property. the difference between the two amounts is Exceptions to General Rule
OID, which is the opposite of bond premium, The following discussion covers exceptions
Settlement payments. Payments received just explained. You include bond premium in to the general rule for canceled debt.
by the landlord in settlement of a tenant’s income if you are the issuer of the bond. You
obligation to restore the leased property to include OID in income if you are the pur- Deductible debt. You do not realize income
its original condition are income in the chaser of the bond. from debt cancellation to the extent that pay-
amount that the payments exceed the ad- OID must be included in your gross in- ment of the debt would have given rise to a
justed basis of the leasehold improvements come as ordinary income even though the deduction.
destroyed, removed, or disconnected by the bond is a capital asset in your hands. How- Example. You own a business and ob-
tenant. ever, if the OID is less than one-fourth of 1% tain accounting services on credit. Later,
of the stated redemption price at maturity when you are having trouble paying your
Interest and Dividend times the number of full years from original business debts (you are not bankrupt or in-
issue to maturity, the OID is considered to be solvent), your accountant forgives part of the
Income zero. amount you owe for the accounting services.
Interest and dividends may be considered OID on a note issued by a municipality is How you treat the cancellation depends on
business income. your method of accounting:
considered tax-exempt interest if the note is
not an industrial development bond or arbi- 1) Cash method – You do not include the
Interest. Interest received on loans is busi-
trage bond. However, any gain on the sale or debt cancellation in income because
ness income if you are in the business of
redemption of a municipal bond is not tax-ex- payment for the services would have
lending money. In any business, interest re-
empt interest. See Publication 550. been deductible as a business expense.
ceived on notes receivable that you have ac-
cepted in the ordinary course of business is For corporate bonds issued before May 2) An accrual method – Your accountant’s
business income. 28, 1969, or for government bonds issued cancellation of the debt must be in-
Discounted loans. If you are in the loan before July 2, 1982, you are not required to cluded in income. This is because,
business, any payment you receive on a dis- include the original issue discount in income under an accrual method of accounting,
counted loan usually includes both principal until the year the bond (or other evidence of the expense is deductible when the lia-
and interest. If you are a cash basis tax- indebtedness) is sold, exchanged, or bility is incurred, not when the debt is
payer, part of the discount is interest income redeemed. paid.
to you when you receive each payment. If If you hold a corporate bond or other evi-
you are an accrual method lender, the dis- dence of indebtedness issued after May 27, For information on the cash and accrual
count is includible in income as it accrues 1969, you must include part of the OID in in- methods of accounting, see chapter 3.
over the term of the loan, or it is includible as come each tax year you own the bond. The
you receive the payments if you receive the rules for figuring how much discount to in- Price reduced after purchase. If you owe
payments before they accrue. clude in income for a tax year are different a debt to the seller for property you pur-
Uncollectible loans. If a loan payable to for obligations issued after July 1, 1982, and chased, and the seller reduces the amount
you becomes uncollectible during the tax obligations issued after December 31, 1984. you owe, generally you do not have income
year, and you are on an accrual method of For information on how much OID to in- from the reduction. The part of the debt re-
accounting, you must include in gross in- clude in income for a tax year, see Publica- duced is treated as a purchase price adjust-
come interest accrued up to the time the tion 1212. ment and reduces your basis in the property.
loan became uncollectible. If the accrued in-
terest later becomes uncollectible, you may Qualified real property business indebt-
be able to take a bad debt deduction. See Dividends. Generally, dividends are busi- edness. You can elect to exclude (up to cer-
chapter 14. ness income to dealers in securities. They tain limits) the discharge of qualified real
Unstated interest. If little or no interest also are business income to partnerships property business indebtedness. (A C corpo-
is charged on an installment sale, unstated and corporations that have invested their ration cannot make this election.) If you
interest is considered to be included in the funds in stocks. To most people engaged in make the election, you must reduce the ba-
payments received. See Unstated Interest in business, however, dividends are nonbusi- sis of your depreciable real property by the
chapter 24. ness income. If an individual holds stock as amount excluded. Make this reduction at the
Bond premium. If a corporation issues a personal investment separately from the beginning of your tax year following the tax
bonds and gets more than the face value of individual’s business activity, the dividends year in which the discharge occurs. How-
the bonds in return, the amount received that from the stock are nonbusiness income. ever, if you dispose of the property before
Chapter 6 BUSINESS INCOME Page 25
that time, you must reduce its basis immedi- income the unpaid interest it had deducted, sells the notes to a finance company, usually
ately before the disposition. but only up to the amount of the deductions for an amount lower than the face value of
Discharge of qualified real property that had lowered its tax in earlier tax years. the notes.
business indebtedness. Qualified real The dealer and the finance company
property business indebtedness is indebted- Bankruptcy. You can exclude a canceled often agree that a part of the price will be
ness (other than qualified farm debt): debt from gross income if the cancellation held by the finance company in a dealer’s
1) That was incurred or assumed in con- takes place in a bankruptcy case under title reserve or similar account until collections
nection with real property used in a 11 of the United States Code (the Bank- are made or the reserve reaches a specified
trade or business, ruptcy Code). However, you must reduce total. Then the finance company pays or
your tax attributes (but not below zero) by credits the amount in the reserve to the
2) That was secured by such real property, dealer. Amounts held in the reserve are con-
the amount excluded. See Publication 908
3) That was incurred or assumed: for more information. sidered income to the dealer.
a) Before January 1, 1993, or Under an accrual method of accounting,
Insolvency. You can exclude canceled the full amount of the discount price, not re-
b) If incurred or assumed on or after that duced by the reserve held by the finance
debt from your gross income but only up to
date, is to acquire, construct, or sub- company, is included in income when the
the amount by which you are insolvent. How-
stantially improve such real property, notes are sold. This practice of discounting
ever, you must reduce your tax attributes
and notes receivable is sometimes used by auto-
(but not below zero) by the amount ex-
4) To which you elect to apply these rules. cluded. See Publication 908 for information mobile dealers.
on insolvency. Losses on worthless notes. Losses on
Qualified real property business indebt- worthless notes that the finance company
edness includes refinancing of indebtedness Qualified farm debt. You can exclude (up can charge against the reserve have no
described in (3) above, but only to the extent to certain limits) from your gross income a bearing on the fact that taxable income has
it does not exceed the indebtedness being cancellation or discharge of qualified farm been received by the dealer.
refinanced. debt if the debt is discharged by a qualified
The amount excluded cannot exceed person. See Cancellation of Debt in chapter Damages. You must include in gross income
either: 4 of Publication 225 for more information. compensation you receive during the tax
1) The excess (if any) of: year as a result of:
a) The outstanding principal of qualified Other Income 1) Patent infringement,
real property business indebtedness The following discussion includes other 2) Breach of contract or fiduciary duty, or
(immediately before the discharge), types of business income you may receive. 3) Antitrust injury.
minus
b) The fair market value (immediately Restricted property. If you receive re- Economic injury. You may be entitled
before the discharge) of the business stricted stock or other property for services to a deduction against the income if it com-
real property that is security for the performed, the fair market value of the prop- pensates you for actual economic injury.
debt, reduced by the outstanding prin- erty in excess of your cost is included in your Your deduction is the smaller of:
cipal amount of any other qualified income when the restriction is lifted. How-
real property business indebtedness 1) The amount you receive or accrue for
ever, you can elect to be taxed in the year
secured by this property immediately damages in the tax year reduced by the
you receive the property. For more informa-
before the discharge, or amount you pay or incur in the tax year
tion on including restricted property in in-
to recover that amount, or
2) The total adjusted bases of depreciable come, see Publication 525.
real property held by you immediately 2) Your loss from the injury that you have
before the discharge. These adjusted Capital gains. Gains from the sale or ex- not yet deducted.
bases are determined after any basis re- change of capital assets are included in your
duction due to a discharge in bank- gross income. Under certain conditions, Punitive damages. You must also in-
ruptcy, insolvency, or of qualified farm some business assets may be treated as clude punitive damages in income.
indebtedness. Depreciable real property capital assets when they are sold or ex-
acquired in contemplation of the dis- changed. See chapter 22. Kickbacks. Any kickbacks that you receive
charge is not taken into account. are included in your income. However, do
Franchises, trademarks, trade names. not include them if you properly treat them
Election. To make this election, com- Amounts you receive or accrue during your as a reduction of a related expense item,
plete Form 982 and attach it to your income tax year that are based on the productivity, cost of goods sold, or a capital expenditure.
tax return for the tax year in which the dis- use, or disposition of a franchise, trademark,
charge occurs. If you do not file the election or trade name are generally includible in Recovery of items previously deducted.
with the original return, you may be able to gross income as ordinary income. See If you recover a bad debt, prior tax, or any
make the election with an amended return or chapter 22. item deducted in a previous year, include the
claim by showing reasonable cause for fail- recovery in your income. However, if all or
ure to file it with the original return. Promissory notes. Negotiable promissory part of the deduction in earlier years did not
notes and other evidences of indebtedness, reduce your tax, you may not have to include
Stockholder canceled debt. If you, as a given to you by a responsible and solvent all of the recovery. Exclude the part that did
stockholder, gratuitously cancel a debt owed maker are reported in gross income at their not reduce your tax. If you exclude part of the
to you by the corporation, the transaction is fair market value when they are received, if recovery from income, you must include with
generally a contribution to the capital of the they are received as a part of your sales your return a computation showing how you
corporation in the amount of the canceled price and you use the cash method of figured the exclusion.
principal portion of the debt, so no income is accounting. Example 1. In 1995, the Maple Corpora-
realized by the corporation. Discounting notes receivable. The dis- tion had gross income of $8,000, a bad debt
However, a solvent, accrual method cor- counting of notes receivable is a common deduction of $300, and other allowable de-
poration may be required to report as income practice in some businesses. Many dealers ductions of $7,700. If, in a later year, the Ma-
any unpaid interest it previously deducted on receive the notes of customers as payment ple Corporation recovers all or part of the
its debt to you. In the year the debt is for- for articles sold. These notes are payable $300 bad debt, it must include the recovery
given, the corporation would include in gross over a fixed period of time. The dealer then in income in the year of recovery.
Page 26 Chapter 6 BUSINESS INCOME
Example 2. Joe Smith, a sole proprietor, to be rendered by the corporation are in- your business, the use of inventories is usu-
had the same income and deductions as the cluded in the corporation’s gross income. ally required to clearly show your income.
Maple Corporation in the preceding exam- For example, to be entitled to receive Dealers in real estate are prohibited from us-
ple. He also had personal exemptions of service, subscribers to a television transmis- ing inventories. See chapter 7 for more infor-
$5,000. He would not pay income tax even if sion service must contribute a specified sum mation on inventories.
he did not deduct the bad debt. Therefore, toward the cost of constructing the facility for
he will not have to report as income any part supplying the television signal. They must Assignment of income. All income you
of the $300 he may recover in any future also pay a monthly maintenance charge. earn is taxable to you. You cannot avoid the
year. The initial contribution is neither a gift nor a tax by having the income paid to a third
Depreciation, depletion, or amortiza- contribution to capital, but is part of the pay- party.
tion. Amounts deducted for these items in a ments for services.
Example. You rent out your property and
previous year are not amounts for which you
can claim no tax benefit was received. You the rental agreement directs the tenant to
Loans. Money borrowed through a bona
must use any net operating loss carryovers pay the rent to your son. The amount paid to
fide loan is not income.
and carrybacks and capital loss carryovers your son is gross income to you.
(or carrybacks for a corporation) to figure Appreciation. Increases in value of your
whether the previous deduction or credit ac- Cash discounts. These are amounts that
property are not income until you realize the
tually reduced your tax for any previous year. increases through a sale or other taxable the seller permits you to deduct from the in-
disposition. voice price for prompt payment. For income
Recapture of depreciation. If your busi- tax purposes you can use either of two meth-
ness use of listed property falls to 50% or Leasehold improvements. If a tenant ods to account for cash discounts. You can:
less in a tax year after the tax year you erects buildings or makes improvements to 1) Deduct the cash discount from
placed the property in service, you may have your property, the increase in the value of purchases (see chapter 7), or
to include in income part of the depreciation the property that is due to the improvements
2) Credit the cash discount to a discount
you deducted in previous years. See Apply- is not income to you. However, if the facts in-
ing the Predominant Use Test in chapter 4 of income account.
dicate that the improvements are a payment
Publication 946. of rent to you, then the increase in value
If you take a section 179 deduction for an You must use the method you select
would be income.
asset and before the end of the asset’s re- every year for all your purchase discounts.
covery period it is not used predominantly in If the second method is used, the credit
Exchange of property for like property. If
business, you must recapture part of the you exchange your business property or balance in the account at the end of your tax
section 179 deduction. You do this by includ- property you hold for investment solely for year is business income. Under this method,
ing in income part of the deduction you took. property of a like kind to be used in your busi- the cost of goods sold is not reduced by the
See When To Recapture the Deduction in ness or to be held for investment, no gain or cash discounts you received. When valuing
chapter 12. loss is recognized. A common type of non- your closing inventory, you cannot reduce
taxable exchange is the trade-in of a busi- the invoice price of merchandise on hand at
ness automobile for another business auto- the close of the tax year by the average or
mobile. See chapter 21. estimated discounts received on the
Items That merchandise.
Are Not Income Consignments. Consignments of merchan-
Trade discounts. These are reductions
dise to others to sell for you are not sales.
In some cases the receipt of property or The title of merchandise remains with you, from list or catalog prices and usually are not
money is not income. the consignor, even after the consignee pos- written into the invoice or charged to the cus-
sesses the merchandise. Therefore, if you tomer. These discounts are not entered on
Issuance of stock. Issuing stock does not ship goods on consignment, you have no your books of account. Only the net amount
produce income for a corporation regardless profit or loss until the merchandise has been is included for purchases. See Trade dis-
of the amount for which the stock was is- sold by the consignee. Merchandise that you counts in chapter 7.
sued. This also applies to the sale of trea- have shipped out on consignment is in-
sury stock. cluded in your inventory until it is sold. Constructive receipt. Income is construc-
Merchandise that you receive on con- tively received when it is credited to your ac-
Contribution to capital. A contribution to signment is never included in your inventory. count or set apart in a way that makes it
capital by an owner or stockholder of a busi- Your profit or commission on merchandise available to you. You do not need to have
ness is not income to the business. For a consigned to you is included in your income physical possession of it. If you use the cash
corporation, contributions to capital by non- when you sell the merchandise or when you method of accounting, report the income in
stockholders are not always included in receive your profit or commission, depend- the year it is constructively received. See
gross income. Contributions to capital or ing upon the method of accounting you use. chapter 3.
other payments to a corporation by persons Example. Frances Jones, a service con-
who are not direct beneficiaries of a service tractor, was entitled to receive a $10,000
rendered or to be rendered by the corpora-
tion are not included in the corporation’s Accounting for payment on a contract in December 1995.
She was told in December that her payment
gross income. However, the basis of prop-
erty contributed or property purchased with
Your Income was available. At her request, she was not
paid until January 1996. She must include
money contributed by nonshareholders Accounting for your income for income tax
this payment in her 1995 income because it
must be adjusted. purposes differs at times from accounting for
was constructively received in 1995.
For example, a contribution made to a financial purposes. This section discusses
Checks. A valid check received before
corporation by a chamber of commerce or some of the more common differences that
the close of the tax year is constructive re-
civic organization to induce the corporation may affect business transactions.
ceipt of income in that year, even though you
to locate in its area is not includible in the The income from your business is figured
do not cash or deposit the check until the fol-
gross income of the corporation. on the basis of a tax year (see chapter 3) and
lowing year.
Contributions to capital or other pay- according to your regular method of ac-
ments to a corporation by persons who are counting (see chapter 3). If the sale of a Example. Dr. Redd received a check for
direct beneficiaries of a service rendered or product is an income-producing factor in $500 on December 31, 1995, from a patient.
Chapter 6 BUSINESS INCOME Page 27
This check was not deposited in her busi- Service agreements. You may postpone that fail to function properly in television sets
ness account until January 2, 1996. This fee reporting income from advance payments that were sold by an unrelated party. You
must be included in her income for 1995. you receive for service agreements on prop- can include the payments in gross income as
Agents. An agent is someone who en- erty you sell, lease, build, install, or con- you earn them over the period of the
gages in business transactions for you. In- struct. This includes agreements providing contract.
come is constructively received by you in the for incidental replacement of parts or materi- Example 3. You own a dance studio. On
year your agent receives it. als. However, this applies only if you offer November 2, 1995, you received payment
Partnerships. If you are a member of a the property without service agreements in for a one-year contract beginning on that
partnership, you are required to include in in- the normal course of business. date and providing for 48 one-hour lessons.
come your share of the partnership profits You gave eight lessons in 1995. Under this
whether or not they are distributed to you. Guarantees and warranties. You generally method of including advance payments, you
For each tax year, include your share of the cannot postpone reporting as income must include one-sixth of the payment in in-
profits from the partnership’s tax year that amounts that you receive under guarantee come for 1995 and five-sixths of the pay-
ends during your tax year or that ends on the or warranty contracts. ment in 1996, even if you cannot give all the
same day that your tax year ends. lessons by the end of 1996.
Debts paid by another person or can- Prepaid rent or prepaid interest. You can-
celed. If your debts are paid by another per- not postpone reporting income from prepaid
son or are canceled by your creditors, you rent or for prepaid interest. Prepaid rent does
Advance Income from Sales
may have to report part or all of this debt re- not include payments for use of rooms or If you use an accrual method of accounting,
lief as income. If you receive income in this other space when significant services are any advance payments you receive for fu-
way, the income is constructively received also provided for the occupant. You provide ture sales or other dispositions of goods are
by you when the debt is canceled or paid. significant services when you supply space included in your income under special rules.
See Canceled Debt, earlier. in hotels, boarding houses, tourist homes, Under these rules, advance payments in-
motor courts, motels, or apartment houses clude those you receive under an agreement
Payment placed in escrow. If part or all of that furnish hotel services. for future sales of goods you hold primarily
the purchase price is placed in escrow by the for sale to your customers in the ordinary
buyer, you do not include any part of it in Postponement not allowed. Usually you course of your trade or business. They also
gross sales until it is actually or construc- may not postpone including in income ad- include payments received under agree-
tively received. However, upon completion vance payments for services if, under the ments for building, installing, or manufactur-
of the terms of the contract and the escrow agreement: ing items if you do not complete the agree-
agreement, you will have taxable income, ment in the tax year.
1) You are to perform any part of the ser- If the advance payments are for con-
even if you do not accept the money until the vices after the end of the tax year imme-
next year. tracts involving both sale and service of
diately following the year you receive goods, it may be necessary to treat them as
the advance payments, or two agreements. An agreement also means
Insurance proceeds. These are discussed
in chapters 17 and 25. 2) You are to perform any part of the ser- a gift certificate that can be redeemed for
vices at any unspecified future date that goods. Amounts that are due and payable
may be after the end of the tax year im- are treated as received.
Sales returns and allowances. Credits you
mediately following the year you receive
allow customers for returned merchandise
the advance payment. Inclusion in income. You may choose
and any other allowances you make on sales
are deductions from gross sales in figuring when to report the advance payments in in-
Any advance payment that you include in come. You may include them in income in
net sales.
gross receipts on your tax return in the tax the tax year in which you receive them or
year you receive the payment cannot be less under an alternative method.
Prepaid Income than the amount of the payment you include
Prepaid income is generally included in your as gross receipts in gross income for your Alternative method. Under an alternative
gross income in the year that it is received. books and records and all your reports (in- method, you generally include advance pay-
However, the amount received is not income cluding consolidated financial statements) to ments in income in the earlier tax year in
unless it is subject to your free and un- shareholders, partners, and other proprie- which:
restricted use. Prepaid income must be tors or beneficiaries, and in reports you pre-
pare for credit purposes. 1) You include the advance payments in
treated this way whether you use the cash or
If you want to change your method of re- gross receipts under the method of ac-
an accrual method of accounting. But, if you
porting advance payments, you must first get counting that you use for tax purposes,
use an accrual method and meet the condi-
consent from the IRS. See chapter 3 for in- or
tions explained in Advance Income for Ser-
vices, next, you may be able to postpone in- formation on how to apply for a change in 2) You include any part of the advance
cluding these amounts in income until the your accounting method. payments in income for any of your fi-
year you earn them. All of the following examples use the cal- nancial reports under the method of ac-
If you must repay any part or all of the endar year as the tax year and an accrual counting used for those reports.
prepaid income in a later year, you can ordi- method of accounting.
narily deduct the repayment in the year you Example 1. You manufacture, sell, and Your financial reports include your re-
make the repayment. See chapter 19. service television sets. In 1995, you received ports to shareholders, partners, benefi-
payment for a one-year contingent service ciaries, other proprietors, for credit pur-
Advance Income for Services contract on a television set you sold. You poses, and for consolidated financial
If you use an accrual method of accounting may postpone including the part of the pay- statements.
and, under an agreement, you receive ad- ment you did not earn in 1995 in income if Example 1. You are a retailer who uses
vance payments for services to be per- you offer the television sets for sale without an accrual method of accounting under
formed by the end of the next tax year, you the contingent service contracts in the nor- which you account for your sales of goods
can make an election to postpone including mal course of your business. when you ship the goods. You use this
the advance payments in income until you Example 2. You are in the television re- method for both tax and reporting purposes.
earn them. However, you cannot postpone pair business. In 1995, you received pay- You must include advance payments you re-
including them beyond the year after the ments for one-year contracts under which ceive in gross receipts for tax purposes ei-
year you receive them. you agree to repair or replace certain parts ther in the tax year you receive the payments
Page 28 Chapter 6 BUSINESS INCOME
or in the tax year you ship the goods. How- end of the second tax year following the tax specified in the contract on hand to satisfy
ever, see Exception for inventory goods, year in which you received substantial pay- the contract. Since the advance payments
later. ments must be included in income for that you had received by the end of 1993 were
Example 2. You are a calendar year tax- second year. Also at the end of this second more than the inventoriable costs you esti-
payer who makes household furniture. You year you must deduct all actual or estimated mated you would have, the payments are
use an accrual method of accounting. Under costs of goods necessary to satisfy the substantial advance payments.
your method of accounting, you accrue in- contract. Include all payments you receive by the
come for your financial reports when you Any difference between the estimated end of 1995, the second tax year following
ship the furniture. For tax purposes, you do and the actual costs in fulfilling the contract the tax year in which you receive substantial
not accrue income until the furniture has must be taken into account when the goods advance payments in income for 1995. You
been delivered and accepted. are delivered. After the second tax year, any must include $40,000 in sales for 1995, and
In 1995, you received an advance pay- more advance payments received on this you must include in your cost of goods sold
ment of $8,000 from a customer for an order contract are reported in income in the year the cost of the goods (or similar goods) on
of furniture to be made for a total price of received because no further deferral is al- hand or, if no such goods are on hand, the
$20,000. You shipped the furniture to your lowable on this contract. estimated inventoriable costs necessary to
customer in December 1995, but it was not Substantial advance payments. Under satisfy the contract.
delivered and accepted until January 1996. an agreement for a future sale, you have Because no further deferral is allowable
You must include the entire $8,000 ad- substantial advance payments if, by the end for the contract, you must include in your
vance payment in your gross income for of a tax year, the total advance payments re- gross income for each remaining year of the
1995. You include the remaining $12,000 of ceived during that year and preceding tax contract the advance payment you receive
the contract price in your gross income for years are equal to or more than the total that year. Any difference between the esti-
1996. costs and expenditures reasonably esti- mated costs and the costs you actually have
Exception for inventory goods. If you mated to be includible in inventory because in satisfying the contract is taken into ac-
receive advance payments under an agree- of the agreement. count in 1998, when you deliver the goods.
ment for the sale of goods that are properly Example. You are a calendar year, ac- Information schedule. If you use this
included in your inventory or under an agree- crual method taxpayer who accounts for ad- alternative method of treating advance pay-
ment, such as a gift certificate, that can be vance payments under the alternative ments for future sales of goods, you must at-
satisfied with goods or a type of goods that method. In 1992, you entered into a contract tach to your income tax return for each tax
cannot be identified in the year of receipt, for the sale of goods that are properly includ- year a statement that shows:
you may be able to postpone including the ible in your inventory. The total contract price 1) Total advance payments you received
advance payments in income in the year of is $50,000 and you estimate that your total in the current tax year,
receipt. The postponement period for these inventoriable costs for the goods will be 2) Total advance payments you received
advance payments may extend only until the $25,000. You receive the following advance in earlier tax years that you have not in-
end of the second tax year following the year payments under the contract: cluded in income before the current tax
in which you received substantial advance
1992 .................................... $17,500 year, and
payments (discussed later) and met the fol-
1993 .................................... $10,000 3) Total payments you received in earlier
lowing conditions:
1994 .................................... $ 7,500 tax years that you have included in in-
1) You must account for advance pay- 1995 .................................... $ 5,000 come for the current tax year.
ments under the alternative method, as 1996 .................................... $ 5,000
discussed earlier, 1997 .................................... 5,000 To change to the alternative method, you
2) You must have received substantial ad- Total contract price $50,000 must first get consent from the IRS. See
vance payments, discussed later, on the chapter 3 for more information on changing
agreement, and Your customer asked you to deliver the your accounting method.
3) You must have on hand or available to goods in 1998. In your 1993 closing inven-
you, through your normal source of sup- tory, you had enough of the type of goods
ply in the year of receipt, enough sub-
stantially similar goods to satisfy the
agreement.
If you meet these conditions at the end of
a tax year, all advance payments (not in-
cluded in income under your accrual ac-
counting method) that you receive by the
Chapter 6 BUSINESS INCOME Page 29
under your accounting method. If such a de-
7. Figuring Cost duction is taken, then those costs and ex-
penses that are incurred in the year of the
of Goods Sold contribution are not treated as resulting in a
basis for the contributed property.
Cost of Goods Add to your beginning inventory the cost of
inventory items purchased during the year, Example 1. You are a calendar year tax-
Sold including all other items entering into the
cost of obtaining or producing the inventory.
payer who uses an accrual method of ac-
counting. In 1995 you contributed property
From this total, subtract your inventory at the from inventory to a church. It had a fair mar-
end of the year. The remainder represents ket value of $600. The closing inventory at
the cost of goods sold during the tax period. the end of 1994 properly included $400 of
Introduction It should not include selling expenses or any
other expenses that are not required to be
costs due to the acquisition of the property,
and in 1994, you properly deducted $50 of
If you make or buy goods to sell, you are enti- included in inventory. administrative and other expenses attributa-
tled to deduct the cost of goods sold on your The following computation of the cost of ble to the property as business expense. The
tax return. You deduct these costs from your goods sold is keyed by numbers to a discus- amount of the charitable contribution al-
gross receipts. However, to determine these sion below of each item used in the lowed for 1995 is $400 ($600 – $200). The
costs, you must maintain inventories. computation. $200 is the amount that would be ordinary in-
Manufacturers, wholesalers, retailers, come if the contributed inventory had been
and every other business that makes, buys, 1. Inventory at beginning of sold at fair market value on the date of the
or sells goods to produce income, must de- year . . . . . . . . . . . . . . . . . . . . . $30,700 gift. The cost of goods sold to be used in de-
termine the value of inventory at the begin- Minus: Cost of termining gross income for 1995 may not in-
ning and the end of each tax year. Invento- merchandise clude the $400. That amount is removed
ries include goods held for sale in the normal contributed to charitable from opening inventory for that year.
course of business as well as raw materials organizations during the
Example 2. If, in Example 1, the contrib-
and supplies that will physically become a year . . . . . . . . . . . . . . . . . . . . . 400 $ 30,300
uted property had been acquired in 1995 at a
part of merchandise intended for sale. Add: cost of $400, the $400 cost of the property
You must take physical inventories at 2. Merchandise (or raw would be included in figuring the cost of
reasonable intervals and the book figure for materials) purchased goods sold for 1995, and the $50 of adminis-
inventory must be adjusted to agree with the during the year . . . . . . . . . $60,000 trative and other expenses attributable to
actual inventory. 3. Labor . . . . . . . . . . . . . . . . . . . 20,000 the property would be allowed as a deduc-
The inventory methods described in this 4. Materials and supplies 4,000 tion for that year. You would not be allowed
chapter apply to sole proprietorships, part- 5. Other costs . . . . . . . . . . . . . 6,000 90,000 any further deduction for the contributed
nerships, and corporations. property.
6. Cost of goods in
inventory . . . . . . . . . . . . . . . $120,300
Accrual accounting method required. If 2. Merchandise or Raw Materials Pur-
Subtract:
you must account for inventories in your bus- chased. For manufacturers or producers,
7. Inventory at end of year 35,000
iness, you must use an accrual method of this includes the cost of all raw materials or
accounting for your purchases and sales. Result: parts purchased for manufacture into a fin-
See chapter 3. 8. Cost of goods sold . . . . . $ 85,300 ished product. For merchants, it includes all
merchandise bought for sale.
Accrual method not required. Personal Trade discounts. The differences be-
service businesses, such as those of doc- 1. Inventory at Beginning of Year. For a tween the stated prices of articles and the
tors, lawyers, carpenters, and painters, usu- manufacturer or producer, the beginning in- actual prices you pay for them are called
ally are not required to use inventories. Their ventory includes the total cost of raw materi- trade discounts. The prices you pay (not the
gross business income usually is the same als, work in process, finished goods, and stated prices) must be used in figuring your
as their gross receipts, and most of them use materials and supplies used in manufactur- cost of purchases. Do not show the discount
the cash method of accounting. However, if ing the goods. For merchants, it consists of amount separately as an item in gross
they also sell or charge for the materials and merchandise held for sale, discussed in In- income.
supplies that are normally used in their busi- ventories in Publication 538. A dealer must record the cost of an arti-
nesses or professions, they must use Opening inventory usually will be identi- cle in inventory reduced by the amount of a
inventories. cal with the closing inventory of the year manufacturer’s rebate that represents a
before. Any difference must be explained in trade discount.
Topics a schedule attached to the return. Cash discounts. Cash discounts are
This chapter discusses: Donation of inventory. If you donate amounts your suppliers let you deduct from
any inventory item to a charitable organiza- your purchase invoices for prompt pay-
● Figuring cost of goods sold tion, the amount of your deductible contribu- ments. There are two methods of accounting
● Inventories tion is the fair market value of the item, less for cash discounts. You may either credit
the amount that would be ordinary income if them to a separate discount account or de-
● Uniform capitalization rules
you had sold the item at its fair market value duct them from total purchases for the year.
on the date of the gift. Whichever method you use, you must be
Useful Items Costs and expenses for the contributed consistent. If you want to change your
You may want to see: property that were incurred in earlier years method of figuring inventory cost, you must
must be removed from opening inventory. get consent from the IRS. See Publication
Publication They are not a part of cost of goods sold for 538.
□ 538 Accounting Periods and Methods figuring gross income for the year of the con- If you credit cash discounts to a separate
tribution. Costs and expenses for the con- account, you must include this credit bal-
Form (and Instructions) tributed property that were incurred in the ance in your business income at the end of
year of the contribution are deductible as the tax year. If you use this method, do not
□ 970 Application To Use LIFO part of cost of goods sold for that year, if this reduce your cost of goods sold by the cash
Inventory Method treatment of costs and expenses is proper discounts.
Page 30 Chapter 7 COST OF GOODS SOLD
Purchase returns and allowances. All Freight-in. Freight-in, express-in, and The rules discussed here only apply if
returns and allowances must be deducted cartage-in on raw materials, supplies that they do not conflict with the uniform capitali-
from your total purchases during the year. are used in production, and merchandise zation rules under the Internal Revenue
Merchandise withdrawn from sale. If that is purchased for sale are all part of cost Code section 263A.
you withdraw merchandise for your personal of goods sold.
or family use, you must exclude this cost Overhead expenses. Overhead ex- Items included in inventory. Inventories
from the total amount of merchandise you penses include such expenses as rent, heat, include all your finished or partly finished
bought for sale. You do this by crediting the light, power, insurance, depreciation, taxes, goods and raw materials and supplies that
purchases or sales account with the cost of maintenance, labor, and supervision. The will become a part of the merchandise you
merchandise you withdraw for personal use. overhead expenses you have as direct and intend to sell.
The amount should be charged to your draw- necessary expenses of the manufacturing Merchandise. You include merchandise
ing account. You should keep a separate ac- operation are included in your cost of goods in your inventory only if you have title to it.
count of all goods you withdraw for personal sold. You include merchandise you purchase in in-
or family use.
ventory if title to it has passed to you, even
6. Cost of Goods Available for Sale. The though it is in transit or you do not have phys-
3. Labor. Labor costs usually are an ele- total of items 1 through 5 represents the cost ical possession of it for some other reason.
ment of cost of goods sold only in a manu- of the goods available for sale during the Your inventory also includes:
facturing or mining business. Small mer- year.
chandising concerns usually do not have 1) Goods under contract for sale that you
labor costs that can properly be charged to 7. Inventory at End of Year. The value of have not yet segregated and applied to
cost of goods sold. However, see Uniform your closing inventory (including, as appro- the contract,
Capitalization Rules, later. In a manufactur- priate, the allocable parts of the cost of raw 2) Goods out on consignment (see Con-
ing business, labor costs that are properly al- materials and supplies, direct labor, and signments in chapter 6), and
locable to the cost of goods sold include overhead expenses) is subtracted from the
both the direct and indirect labor used in amount in item 6. 3) Goods that are in display rooms, mer-
fabricating the raw material into a finished, chandise mart rooms, or booths that are
salable product. 8. Cost of Goods Sold. When your closing located away from your place of
Direct labor. Direct labor costs are the inventory is subtracted from the cost of business.
wages paid to those employees who spend goods in inventory, the remainder is your
all their time working directly on the product cost of goods sold during the tax year. When In figuring gross income, you may be per-
being manufactured. They also include a you subtract your cost of goods sold from mitted to account for the sale of your product
part of the wages paid to employees who your adjusted gross receipts, the remainder when the goods are shipped, when the prod-
work directly on the product part time, if that is your gross profit from sales. See the illus- uct is delivered or accepted, or when title to
part of their wages can be determined. tration in chapter 8. the goods passes to the customer, whether
Indirect labor. Indirect labor costs are or not billed, depending upon the method
the wages paid to employees who perform a
you use for keeping your books. Do not in-
general factory function that does not have
clude the goods you have sold in your
any immediate or direct connection with Inventories inventory.
making the salable product, but that is a nec-
Inventories are necessary to clearly show in- Containers. You include containers in
essary part of the manufacturing process.
come when the production, purchase, or your inventory if title to them has not passed
Other labor. Other labor costs that are
sale of merchandise is an income-producing to the buyer of the contents. Containers in-
not properly chargeable to the cost of goods
factor in your business. clude such items as kegs, bottles, and
sold may be deducted as selling or adminis-
The most common kinds of inventories cases, whether or not on hand and whether
trative expenses. Generally, if the uniform
are: or not returnable. If title has passed to a
capitalization rules do not apply, the only
buyer, you exclude the containers from in-
kinds of labor costs that are properly charge- 1) Merchandise or stock in trade, ventory. Under certain circumstances, some
able to your cost of goods sold are the direct
or indirect labor costs, and certain other 2) Raw materials, containers may be depreciated. See Con-
costs that are treated as overhead expenses 3) Work in process, tainers in chapter 12.
properly charged to the manufacturing pro- C.O.D. mail sales. If you sell merchan-
4) Finished products, and dise by mail and intend payment and delivery
cess, as discussed below under Other
Costs. 5) Supplies that physically become a part to happen at the same time, title passes
of the item intended for sale. when payment is made. Include the mer-
4. Materials and Supplies. Materials and chandise in your closing inventory until the
supplies, such as hardware and chemicals, The value of inventories at the beginning and buyer pays for it.
used in manufacturing goods are charged to end of each tax year is required to determine
cost of goods sold. Those that are not used taxable income. To determine the value of Items excluded from inventory. Exclude
in the manufacturing process are treated as your inventory, you need a method for iden- from your inventory all goods you have sold,
deferred charges, deductible as a business tifying the items in your inventory and a but be sure that the title to them has passed
expense when used. For additional informa- method for valuing these items. to the buyer. Also exclude goods in your pos-
tion, see Business expenses in chapter 4. Inventory valuation rules cannot be the session that are consigned to you and goods
same for all kinds of businesses. The you ordered for future delivery if you do not
5. Other Costs. Examples of other costs in- method you use must conform to generally yet have title to them. See Consignments in
curred in a manufacturing or mining process accepted accounting practices used for simi- chapter 6.
that are chargeable to your cost of goods lar businesses, and it must clearly show in- Other assets. Other assets such as
sold are as follows. come. To clearly show income, you must land, buildings, and equipment used in your
Containers. Containers and packages consistently use the same inventory method business, as well as notes and accounts re-
that are an integral part of the product manu- from year to year. ceivable, and similar assets, are not included
factured are a part of your cost of goods The value of your inventory may include in your inventory. Also, real estate held for
sold. If they are not an integral part of the certain capitalized costs. These rules are ex- sale by a real estate dealer in the ordinary
manufactured product, their costs are ship- plained later under Uniform Capitalization course of business is not included in
ping or selling expenses. Rules. inventory.
Chapter 7 COST OF GOODS SOLD Page 31
Cost Identification annual gross receipts of $5 million or less for the cost method, the value of your closing
the 3 preceding tax years. For information on inventory would be $950.
There are three methods of identifying items this method, see section 474 of the Internal Market value. Under ordinary circum-
in inventory—specific identification, first-in Revenue Code. stances and for normal goods, market value
first-out (FIFO), and last-in first-out (LIFO).
means the usual bid price at the date of your
Valuing Inventory inventory. This price is based on the volume
Specific identification method. The spe- of merchandise you usually buy. For exam-
cific identification method is used to identify Since valuing the items in your inventory is a ple, if you buy items in small lots at $10 an
the cost of each inventoried item by match- major factor in figuring your taxable income, item and a competitor buys identical items in
ing the item with its cost of acquisition in ad- the method you use to value your inventory larger lots at $8.50 an item, your usual mar-
dition to other allocable costs, such as labor is very important. The two common methods ket price is higher than your competitor’s.
and transportation. to value non-LIFO inventory are the cost
The lower of cost or market rule applies
If there is no specific identification of method and the lower of cost or market
to goods purchased and on hand, and to ba-
items with their costs, you must make an as- method.
sic elements of cost (direct materials, direct
sumption to decide which items were sold For a new business not using LIFO, you
labor, and an allocable share of indirect
and which remain in inventory. Make this may select either method to value your in-
costs) of goods in process of manufacture
identification by either the FIFO method, or ventory. You must use the same method to
and finished goods on hand. It does not ap-
the LIFO method. value your entire inventory, and you may not
ply to goods on hand or in process of manu-
change to another method without consent
facture for delivery at fixed prices on a firm
FIFO and LIFO methods. The FIFO from the IRS.
sales contract (that is, not legally subject to
method assumes that the items you pur- cancellation by either you or the buyer).
chased or produced first are the first items Cost method. To properly value your inven- These goods must be inventoried at cost.
you sold, consumed, or otherwise disposed tory at cost, you must include all direct and Lower than market. When, in the regu-
of. indirect costs that are associated with it. Ap- lar course of business, you have offered
The items in inventory at the end of the ply the following rules: merchandise for sale at prices lower than
tax year are valued as the items most re- 1) For merchandise on hand at the begin- market, the inventory may be valued at these
cently purchased or produced. If there is in- ning of the tax year, cost means the in- prices, less the direct costs of disposition.
termingling of the same type of goods in your ventory price of the goods. Figure these prices from the actual sales for
inventory so that they cannot be identified a reasonable period before and after the
with specific invoices, you must use the FIFO 2) For merchandise purchased during the
date of your inventory. Prices significantly
method to value these items, unless you year, cost means the invoice price less
different from the actual prices determined
elect to use the LIFO method. appropriate discounts plus transporta-
are not acceptable as reflecting the market.
tion or other charges you incur in acquir-
The LIFO method assumes that the No market exists. If no market exists, or
ing the goods. In addition, see Uniform
items of inventory that you purchased or pro- if quotations are given without reference to
Capitalization Rules, later, for any addi-
duced last are sold or removed from inven- actual conditions because of an inactive
tional cost that may have to be included
tory first. Items included in your closing in- market, you must use whatever evidence of
in the inventoriable cost of goods
ventory are considered to be, first, those a fair market price is available, at the dates
purchased.
from the opening inventory in order of acqui- nearest your inventory date. This evidence
sition and, second, those items acquired in 3) For merchandise produced during the could include specific purchases or sales
the tax year. year, cost means all direct and indirect you or others made in reasonable volume
The FIFO method and the LIFO method costs that must be capitalized under the and in good faith, or compensation paid for
produce different results in income depend- uniform capitalization rules. cancellation of contracts for purchase
ing on the trend of price levels of the goods commitments.
included in those inventories. In times of in- Discounts. You must reduce the cost of Unsalable goods. Unsalable goods are
flation when prices are rising, LIFO will pro- your inventory by trade discounts for volume goods in your inventory that you cannot sell
duce a larger cost of goods sold and a lower purchases. You may choose whether to de- at normal prices or in the usual way because
closing inventory. Under FIFO, the cost of duct cash discounts for prompt payment, but of damage, imperfections, shop wear,
goods sold will be lower and the closing in- you must treat them the same way from year changes of style, odd or broken lots, or other
ventory will be higher. However, in times of to year. If you do not deduct the cash dis- similar causes, including secondhand goods
falling prices, LIFO will generally produce a counts from your inventory costs, you must taken in exchange. You value these goods at
smaller cost of goods sold and may produce include them in your business income. selling prices minus direct costs of disposi-
a higher closing inventory. Under FIFO the tion, no matter what method you use to value
reverse will be true. Lower of cost or market method. Lower the rest of your inventory. If these goods
Adopting LIFO method. To adopt the of cost or market means that you compare consist of raw materials or partly finished
LIFO method, you must file Form 970, or a the market value of each item on hand at the goods held for use or consumption, they are
statement that has all the information re- inventory date with its cost and use the lower valued on a reasonable basis, considering
quired in Form 970. You must file the form value as its inventory value. If at the end of the usability and condition of the goods. Do
(or the statement) with your timely filed tax your tax year you had the following items on not value them for less than scrap value.
return for the year in which you first use hand, the value of your closing inventory
LIFO. would be $600. Perpetual or book inventories. You may
You may qualify for an automatic exten- figure the cost of goods on hand by perpet-
Whichever
sion of 12 months to make this election; see ual or book inventories if you use sound ac-
Items Cost Market is lower
Revenue Procedure 92–85 for more counting practices. Inventory accounts,
information. R . . . . . . . . . . . . . . . . . . . . $300 $500 $300 however, are charged with the actual cost of
There are very complex rules involved in S . . . . . . . . . . . . . . . . . . . . 200 100 100 goods purchased or produced, and credited
using the LIFO method that are not dis- T . . . . . . . . . . . . . . . . . . . . 450 200 200 with the value of goods used, transferred, or
cussed in this publication. For more informa- Totals $950 $800 $600 sold. Credits are figured on the basis of the
tion, see the regulations under section 472 actual cost of goods acquired during the
of the Internal Revenue Code. If you use this method, you must value each year and the inventory value at the beginning
An eligible small business may elect the item in the inventory. You may not value the of the year.
simplified dollar-value LIFO method. An entire inventory at cost ($950) and at market Physical inventories. You must take
eligible small business is one with average ($800) and use the lower figure. If you use physical inventories at reasonable intervals
Page 32 Chapter 7 COST OF GOODS SOLD
and the book figure for inventory must be ad- portion of most indirect costs that benefit or connected with a trade or business or
justed to agree with the actual inventory. are incurred because of production or resale an activity conducted for profit;
activities. This means that certain expenses
Practices not approved. The following are you have during the year are included in the 3) Research and experimental expendi-
some of the inventory practices that are not basis of property you produce or in your in- tures deductible under section 174;
recognized for tax purposes: ventory costs, rather than claimed as a cur-
rent deduction. You will recover these costs 4) Intangible drilling and development
1) Deducting a reserve for price changes
through depreciation, amortization, or cost costs of oil and gas or geothermal wells,
or an estimated amount for depreciation
of goods sold when you use, sell, or other- or any amortization deduction allowable
in the value of your inventory,
wise dispose of the property. under Internal Revenue Code section
2) Taking work in process or other parts of 59(e) for intangible drilling, develop-
your inventory at a nominal price or less You are subject to the uniform capitaliza-
tion rules if, in the course of a trade or busi- ment, or mining exploration
than its full value, expenditures;
ness or an activity carried on for profit, you:
3) Omitting part of your stock on hand,
1) Produce real or tangible personal prop- 5) Property you produce under a long-term
4) Using a constant price or nominal value
erty for use in the business activity, contract, except for certain home con-
for so-called normal quantity of materi-
struction contracts described in Internal
als or goods in stock, 2) Produce real or tangible personal prop-
Revenue Code section 460(e)(1);
5) Including stock in transit, shipped either erty for sale to customers, or
to or by you, the title to which you do not 3) Acquire property for resale. However, 6) Timber and certain ornamental trees
hold, this rule does not apply to personal you raise, harvest, or grow, and the un-
6) Separating indirect production costs property if your average annual gross derlying land;
into fixed and variable production cost receipts for the preceding 3 tax years
classifications and then allocating only are not more than $10 million. 7) Qualified creative expenses you incur
the variable costs to cost of goods pro- as a free-lance writer, photographer, or
duced while treating fixed costs as pe- artist;
You produce property if you construct, build,
riod costs that are currently deductible install, manufacture, develop, improve, cre-
(the direct cost method), or 8) Costs allocable to natural gas acquired
ate, raise, or grow the property. Property pro- for resale, to the extent these costs
7) Treating all or almost all indirect produc- duced for you under a contract is treated as would otherwise be allocable to ‘‘cush-
tion costs (whether fixed or variable) as produced by you to the extent that you make ion gas’’ stored underground;
period costs that are currently deducti- payments or otherwise incur costs for the
ble (the prime cost method). property. 9) Property produced if substantial con-
Tangible personal property includes struction occurred before March 1,
Gains and losses. If items included in in- films, sound recordings, video tapes, books, 1986;
ventory are damaged by a fire or other casu- artwork, photographs, or similar property.
alty, or are stolen, a casualty or theft loss However, free-lance authors, photogra- 10) Property provided to customers incident
may result. You do not claim a loss if the cost phers, and artists may be exempt from the to the provision of services, if it is de
of the damaged or lost goods has been in- uniform capitalization rules. See Publication minimis in amount and not inventory in
cluded in cost of goods sold. See Loss of in- 538 for more information. the hands of the service provider; and
ventory in chapter 25. Any loss from casualty For information about how the capitaliza-
or theft is reflected in the cost of goods sold. tion rules apply to certain inventory methods, 11) The origination of loans.
Sale of entire inventory. You must in- see section 1.263A of the Income Tax Regu-
clude the total amount you receive from the lations.
sale of your entire inventory on your return De minimis exception. The costs of certain
as ordinary income. For the sale of your en- producers using a simplified production
tire inventory, such as when you sell or dis- Exceptions. The uniform capitalization method are not subject to the uniform capi-
pose of your business, see Sale of a Busi- rules do not apply to: talization rules if their total indirect costs are
ness in chapter 27. 1) Resellers of personal property with av- $200,000 or less. See section 1.263A–
erage annual gross receipts for the 3 2(b)(3)(iv) of the Income Tax Regulations for
more information.
Uniform Capitalization prior tax years of not more than $10
Special uniform capitalization rules apply
million;
Rules to farming businesses. See Special Rules for
Under the uniform capitalization rules, you 2) Property you use for personal or non- Farm Property, in Publication 225, Farmer’s
must capitalize direct costs and an allocable business purposes, or for purposes not Tax Guide.
Chapter 7 COST OF GOODS SOLD Page 33
Income Statement forms are available at office supply stores.
Year Ended December 31, 1995 These forms have columns for recording the
8. description, quantity, unit price, and value of
each inventory item. Each page has space to
Gross receipts . . . . . . . . . . . . . . . . . . . . . . . . . $400,000
Gross Profit Minus: Returns and allowances . . . . . . . 14,940
record who made the physical count, who
priced the items, who made the extensions,
Net receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . $385,060 and who proofread the calculations. These
Minus: Cost of goods sold . . . . . . . . . . . . . 288,140 forms will help satisfy you that the total in-
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,920 ventory is accurate. They will also provide
you with a permanent record to support its
validity.
Introduction The cost of goods sold for this business Inventories are discussed in chapter 7.
is figured as follows:
After you have figured the gross receipts
from your business (chapter 6) and the cost Testing Gross
of goods sold (chapter 7), you are ready to Inventory at beginning of year . . . . . . . . . $ 37,845 Profit Accuracy
figure your gross profit. You must determine Plus: Purchases . . . . . . . . . . $285,900 If you are in a retail or wholesale business,
gross profit before you can take any deduc- Minus: Items withdrawn you can check the accuracy of your gross
tions for business operations. These deduc- for personal use . . . . . . . . 2,650 283,250 profit figure. First, divide gross profit by net
tions are discussed in Part 4 of this book. Goods available for sale . . . . . . . . . . . . . . . $321,095 receipts. The resulting percentage mea-
Minus: Inventory at end of year . . . . . . . . 32,955 sures the average spread between the mer-
chandise cost of goods sold and the selling
Topics Cost of goods sold . . . . . . . . . . . . . . . . . . . $288,140
price.
This chapter discusses: Next, compare this percentage to your
markup policy. Little or no difference be-
● Figuring gross profit tween these two percentages shows that
Points to Check your gross profit figure is accurate. A large
● Testing gross profit accuracy difference between these percentages may
Consider the following items before figuring show that sales, purchases, inventory, or
● Additions to gross profit your gross profit. other items of cost have not been figured ac-
curately. The reason for the difference
Useful Items should be determined.
Gross receipts. Even very small busi-
You may want to see: Example. Joe Able operates a retail bus-
nesses find it helpful to use cash registers to
iness. On the average, he marks up his mer-
keep track of receipts. You should also use a
chandise so that he will realize a gross profit
proper invoicing system and keep a separate
Publication of 33 1/ 3 % on its sales. The net receipts
bank account for your business. At the end
(gross receipts minus returns and al-
□ 538 Accounting Periods and Methods of each business day, make sure your
lowances) shown on his income statement
records balance with your actual cash and
for 1995 is $300,000. His cost of goods sold
credit receipts for the day.
is $200,000. This results in a gross profit of
$100,000 ($300,000 – $200,000). To test
Figuring Gross Profit Sales tax collected. Check to make sure the accuracy of this year’s results, Joe di-
vides gross profit ($100,000) by net receipts
your records show the correct sales tax
To figure your gross profit, first figure your collected. ($300,000). The resulting 33 1/ 3% confirms
net receipts. Do this by subtracting any ‘‘re- his markup policy of 331/ 3%.
turns and allowances’’ from gross receipts.
Returns and allowances include cash or Inventory at beginning of year. Compare Additions to Gross Profit
credit refunds you make to customers, re- this figure with last year’s ending inventory. If your business has income from a source
bates, and other allowances off the actual The two amounts should be the same. other than its regular business operations,
sales price. add that income to gross profit. Examples in-
Next, subtract the cost of goods sold clude income from an interest-bearing
from net receipts. The result is the gross Purchases. If you take any inventory items checking account, income from scrap sales,
profit from your business. for your personal use — use them yourself, amounts recovered from bad debts, and
You do not have to figure the cost of provide them to your family, or give them as other kinds of miscellaneous income from
goods sold if the sale of merchandise is not personal gifts, etc. — be sure to remove your business.
an income-producing factor for your busi- them from the cost of goods sold. Subtract
ness. Your gross profit is the same as your the amount from your purchases for the
net receipts—gross receipts minus any re- year.
funds, rebates, or other allowances. Most
professions and businesses that sell ser-
vices rather than products can figure gross Inventory at end of year. Check to make
profit directly from net receipts in this way. sure your procedures for taking inventory are
adequate. These procedures should provide
you with a way of making sure that all items
Illustration. This illustration of the gross have been included in the inventory and that
profit section of the income statement of a proper pricing techniques have been used.
retail business shows how gross profit is Avoid using adding machine tapes as the
figured. only evidence for your inventory. Inventory
Page 34 Chapter 8 GROSS PROFIT
Part Four.
Figuring Net This Part discusses business expenses that you can deduct from gross
profit to figure the net income or loss of your business. Business expenses
are the normal and current costs of operating a business.
Income or
To be deductible, a business expense must be ordinary in your business
Loss and necessary for its operation. An ordinary expense is one that is common
and accepted in your field of business, trade, or profession. A necessary
expense is one that is helpful and appropriate for your business. An
expense does not have to be indispensable to be considered necessary.
If you have an expense that is partly for business and partly personal, you
must separate the personal part from the business part. Only the business
part is deductible.
Useful Items 3) The character and amount of
You may want to see: responsibility.
9. 4) The complexities of your business.
Publication
5) The time required.
Employees’ Pay □ 535 Business Expenses
6) The general cost of living in the locality.
Form (and Instructions) 7) The ability and achievements of the indi-
□ W–2 Wage and Tax Statement vidual performing the service.
□ 4782 Employee Moving Expense 8) The pay compared with the gross and
Important Change Information net income of the business and with the
distributions to shareholders if the busi-
for 1995 ness is a corporation.
Caution. The income exclusion provision
for employer-provided educational assis-
Tests for Deductibility 9) Your policy regarding pay for all of your
employees.
tance does not apply after 1994. However, To be deductible, an employee’s pay must
10) The history of pay for each employee.
as the publication was being prepared for meet all of the following tests.
print, Congress was considering legislation
Individual salaries. You must base the
to extend the provision. See Publication 553, Test 1 — Ordinary and necessary. You
test of whether or not a salary is reasonable
Highlights of 1995 Tax Changes, for further must be able to show that a salary, wage, or
on each individual’s salary and the services
developments. other payment for services an employee ren-
performed, not on the total salaries paid to
ders is an ordinary and necessary expense
all officers or all employees. For example,
and is directly connected with your trade or
even if the total amount you pay to your of-
business.
Introduction The fact that you pay your employee for a
ficers is reasonable, you still cannot deduct
an individual officer’s salary if it is not rea-
legitimate business purpose is not sufficient,
Salaries, wages, and other forms of pay you sonable based on the factors listed above.
by itself, for you to deduct the amount as a
give employees for work they perform in your business expense. You can deduct a pay-
business are generally deductible business ment for the services of your employee only Test 3 — For services performed. You
expenses. However, you must reduce your if the payment is ordinary and necessary to must be able to prove the payment was
deduction for salaries and wages by any cur- carry on your trade or business. made for services actually performed.
rent tax year employment credits. For more
information, see the employment credit Test 2 — Reasonable. The reasonable- Test 4 — Paid or incurred. You must have
forms listed in chapter 31. ness of pay is determined by the facts. Gen- actually made the payment or incurred the
erally, reasonable pay is the amount that expense during the tax year.
would ordinarily be paid for these services by If you use the cash method of account-
Topics ing, deduct your expense for the salary or
This chapter discusses: like enterprises under similar circumstances.
You must be able to prove that the pay is wage in the year it is paid to the employee.
● Tests for deductibility reasonable. This test is based on the circum- If you use an accrual method of account-
stances at the time you contract for the ser- ing, deduct your expense for the salary or
● Cash payments wage when you establish your obligation to
vices, not those existing when the reasona-
bleness is questioned. If the pay is make the payment and when economic per-
● Noncash payments
excessive, you can deduct only the part that formance occurs. Economic performance
● Other payments is reasonable. generally occurs as an employee performs
Factors to be considered. To deter- his or her services for you. The economic
● Employee benefit programs performance rule is discussed in chapter 3.
mine if pay is reasonable, consider the fol-
● Meals and lodging furnished to lowing factors and any other pertinent data. Your payment need not be made in the year
employees the obligation exists. It can be deferred to a
1) The duties performed by the employee. later date, but special rules apply. See Un-
● Exclusion of fringe benefits 2) The volume of business handled. paid Salaries, later.
Chapter 9 EMPLOYEES’ PAY Page 35
Cash basis taxpayer. If you are a cash ba- method of accounting. Frank Wilson, an of-
Cash Payments sis taxpayer, you can deduct vacation pay as
wages when you pay an employee.
ficer of the corporation, uses the calendar
year and the cash method of accounting. At
Some of the ways you may provide cash the close of calendar year 1995, he owns
compensation to your employees are dis- Accrual basis taxpayer. If you are an ac- 50% of the outstanding stock of the corpora-
cussed next. crual basis taxpayer, you can deduct vaca- tion. On March 4, 1996, he acquires addi-
tion pay earned by an employee as wages in tional shares that bring his holdings up to
Bonuses and Gifts the year earned only if you pay it: 51%. At the end of December 1995, the cor-
poration accrues salary of $1,000 payable to
You can deduct bonuses and gifts to your 1) By the close of your tax year, or
Frank.
employees if they meet certain conditions. 2) If the amount is vested, within 21/ 2 The Lomar Corporation pays Frank $600
months after the close of the year. on January 30, 1996, and the balance by
Bonus. You can deduct a bonus paid to an
March 14, 1996. The corporation can deduct
employee if you intended the bonus as addi- You deduct the vacation pay in the year the salary of $1,000 in 1995. Frank and the
tional pay for services, not as a gift, and the actually paid if you pay it later than this. Lomar Corporation are not related taxpayers
bonus is paid for services actually per-
at the close of Lomar’s 1995 tax year.
formed. However, to deduct the amount as
wages, the total bonuses, salaries, and other Unpaid Salaries
pay must be reasonable for the services per- If you have a definite, fixed, and uncondi- Guaranteed Annual Wage
formed. The bonus is included in an employ- tional agreement to pay an employee a cer- If you guarantee to pay certain employees
ee’s income. You can pay a bonus in cash, tain salary for the year, but you defer paying full pay during the year (determined by the
property, or a combination of both. part of it until the next tax year, your deduc- number of hours in your normal work year)
tion for the salary is based on the following under terms of a collective bargaining agree-
Gifts of nominal value. If, in order to pro- factors. ment, you can deduct the pay as wages. You
mote employee goodwill, you distribute tur- must include the payments in the employ-
1) If you use an accrual method of ac-
keys, hams, or other merchandise of nomi- ees’ income and they are subject to FICA
counting, you can deduct the entire sal-
nal value to your employees at holidays, the and FUTA taxes and income tax withholding.
ary in the first year if economic perform-
value of these items is not salary or wages. ance has occurred (the employee
You can deduct the cost of these items as a
business expense.
performed the services in that year). Compensation for
If you distribute cash, gift certificates, or 2) If you use the cash method of account- Sickness and Injury
similar items of easily convertible cash ing, only the amount actually paid each
You can deduct as compensation amounts
value, the value of these items is considered year can be deducted that year.
you pay to your employees for sickness and
additional wages or salary regardless of the injury, including lump-sum amounts. How-
amount or value. See Business Gift Ex- If no definite prior arrangement was ever, your deduction is limited to amounts
penses in chapter 15 for more information made, only the amount paid in the first year not compensated by insurance or other
on gifts. can be deducted that year because no fixed means.
For information on achievement, safety, obligation exists to make the later payments.
and other awards, see chapter 2 in Publica- This is the same for the cash method and
tion 535. any accrual method.
Noncash Payments
Special rule for accrual method payer. If
Loans or Advances you use an accrual method of accounting, You may pay your employees in property
You can generally deduct as wages a loan or you cannot deduct salaries, wages, and other than cash, such as property used in
advance you make to an employee that you other expenses owed to a related person (as your business or shares of your company
do not expect the employee to repay if it is defined in chapter 3) until: stock. You may also pay expenses for your
for personal services actually performed. employees, such as tuition for nonjob-re-
The total must be reasonable when the loan 1) The tax year you make the payment, lated courses or the cost of moving to an-
or advance is added to the employee’s other and other location. These items are discussed
compensation, and it must meet the tests for 2) The amount is includible in the income next.
deductibility, discussed earlier. However, if of the person paid.
the services are not performed, the amount Education Expenses
you advanced to the employee is treated as This rule applies even if you and that person If you pay or reimburse education expenses
a loan and it cannot be deducted as cease to be related taxpayers prior to the for an employee enrolled in a course not re-
compensation. time the amount is includible in that person’s quired for the job or not otherwise job re-
gross income. lated, deduct the payment as wages. You
Below-market interest rate loans. On cer- Example 1. Tom Green runs a retail must include the payment in your employ-
tain loans you make to an employee or store as a sole proprietor. He uses the calen- ee’s income and it is subject to FICA and
stockholder, you may be considered to have dar year and an accrual method of account- FUTA taxes and income tax withholding.
received interest income and to have paid ing. His brother, Bob, works for him and is
compensation or dividends equal to that in- paid $1,000 a month. Bob uses the calendar
terest. For more information, see Below- year and the cash method of accounting. At
Moving Expenses
Market Interest Rate Loans in chapter 16. the end of 1995, Tom accrues Bob’s Decem- Deduct as a qualified fringe benefit amounts
ber salary. you reimburse employees or pay on their be-
Vacation Pay Because of a temporary cash shortage, half for qualified moving expenses. Qualified
Tom pays Bob $600 on January 12, 1996, moving expenses are those the employee
Vacation pay is an amount you pay or will
and the $400 balance on April 1, 1996. Tom could deduct if he or she paid or incurred
pay to your employee while the employee is
cannot deduct the $1,000 until 1996, the them directly. They include only the reasona-
on vacation. It includes an amount you pay
year Bob must include the amount in his ble expenses of:
an employee even if the employee chooses
not to take a vacation. Vacation pay does income. 1) Moving household goods and personal
not include any amount for sick pay or holi- Example 2. The Lomar Corporation effects from the former home to the new
day pay. uses the calendar year and an accrual home, and
Page 36 Chapter 9 EMPLOYEES’ PAY
2) Traveling (including lodging) from the not likely to have to give up his or her rights poor history of paying dividends on its out-
former home to the new home. in the property in the future. standing stock.
The amount and the year in which you If your corporation uses an accrual
Qualified moving expenses do not in- can deduct the payment will vary, depending method of accounting and the salary is un-
clude any expenses for meals. in part on the kind of property interest you paid at the end of the tax year, see Unpaid
Deduct as wages any payment you make transfer. The amount you can deduct de- Salaries, earlier, to determine how to handle
as an allowance or reimbursement for a non- pends on the amount included in the recipi- the deduction.
qualified moving expense (i.e., an expense ent’s income. For tax years beginning after
the employee cannot deduct). You must in- 1994, you must report the amount on a Relative. You can deduct the salary or
clude the payment in the employee’s in- timely filed Form W–2 or Form 1099–MISC wage paid to a relative who is an employee,
come. The payment is wages for income tax (even if the recipient is a corporation) in or- including your minor child, if the four tests for
withholding and FICA and FUTA taxes. You der to take the deduction. However, no re- deductibility, discussed earlier, are met.
treat the reimbursement to the employee as porting is required if the transfer: However, also see Unpaid Salaries, earlier.
payment for services. You can deduct the
1) Is exempt from reporting because the
amount if it meets the deductibility tests dis- Payment to a beneficiary of a deceased
payment is less than the $600 reporting
cussed earlier. employee. You can deduct a payment you
requirement for Form 1099–MISC, or
make to an employee’s beneficiary because
Statement to employee. You must give the 2) Meets any other reporting exception of the employee’s death if the payment is
employee a statement describing the pay- that applies to a recipient other than a reasonable in relation to past services per-
ments made to the employee, or on his or corporation.
formed by the employee. The payment must
her behalf, for moving expenses. The state- also meet the tests for deductibility, dis-
ment must contain sufficient information so cussed earlier.
the employee can properly figure the allowa-
ble moving expense deduction. You may use
Form 4782 for this purpose. You must give Other Payments
this information to your employee by January Employee Benefit
31 of the year following the year in which you Construction of capital assets. You can-
make the payments. not deduct salaries and other wages in- Programs
curred for constructing capital assets. In- You may provide forms of pay other than
Form W–2. You must also show any reim- stead, you include them in the basis of the cash to your employees. These include life,
bursement for moving expenses on the em- asset and recover your cost through depreci- health, or accident insurance, educational
ployee’s Form W–2. However, any amount ation deductions. See chapter 12. assistance, and other benefit programs. Life
considered a qualified fringe benefit is re- and health insurance are discussed in chap-
ported in box 13, not box 1, Wages, tips, Cost of goods sold. Generally, you must ter 17. The following discussion explains the
other compensation. capitalize or include in inventory the wages costs you can and cannot deduct, how to
and salaries you pay employees to produce claim a deduction on your tax return,
More information. For more information on real or tangible personal property or to ac- whether it is includible or excludable from
moving expenses, see Publication 521. For quire property for resale. If the property is in- your employee’s income, and whether it is
information on excluding fringe benefits, see ventory, add the wages to inventory. Capital- subject to employment and income tax
chapter 4 in Publication 535. ize the costs for any other property. Personal withholding.
property acquired for resale is not subject to
Capital Assets this rule if your average annual gross re-
Dependent Care
If you transfer a capital asset or an asset ceipts for the 3 preceding tax years are
used in your business to one of your employ- $10,000,000 or less. You can deduct these Assistance
ees as payment for services, you can deduct wages as a current business expense. For You can deduct the expenses for providing
as wages its fair market value on the date of more information on the uniform capitaliza- dependent care assistance to your employ-
the transfer less any amount the employee tion rules, see chapter 7. ees. If you provide the care in-kind (i.e., oper-
paid for the property. You treat the deducti- ate a dependent care facility for your em-
ble amount as received in exchange for the Employee-stockholder. A salary paid to an ployees), deduct the costs of operating the
asset, and you must recognize any gain or employee who is also a stockholder must care facility in the appropriate categories
loss realized on the transfer. You figure gain meet the same tests for deductibility, dis- (depreciation, utilities, salaries, etc.) on your
or loss on the difference between the fair cussed earlier, as the salary of any other ex- return. If you contract with a third party to
market value of the asset and its adjusted ecutive or employee. provide the care, or if you reimburse your
basis on the date of the transfer. See chap- You cannot deduct a payment to an em- employees directly for the dependent care
ter 22. ployee-stockholder that is not for services expenses they incur, deduct your costs on
performed. The payment may be a distribu- the Employee benefit programs line of your
tion of dividends on stock. This is most likely tax return or schedule.
Payment in to occur in a corporation with few sharehold- If you have a dependent care assistance
Restricted Property ers, practically all of whom draw salaries. A program that meets the requirements, you
In general, restricted property is property salary paid to an employee-stockholder that can exclude from each employee’s income
subject to a condition that significantly af- is more than the salary ordinarily paid for up to $5,000 of assistance each year. In-
fects its value. similar services and that bears a close rela- clude the entire amount paid to your em-
If you transfer property, including stock in tionship to the stock holdings of the em- ployee or paid on your employee’s behalf in
your company, as payment for services and ployee is probably not paid wholly for ser- box 10 of your employee’s 1995 Form W–2.
the property is considered substantially vices performed. The salary may include a If you furnished the care in-kind, use the fair
vested in the recipient, you generally have a distribution of earnings on the stock. market value of the dependent care pro-
deductible ordinary and necessary business However, if the payment to an employee- vided to that employee, less any amount the
expense. stockholder of a closely held corporation employee paid you for the care. The fair mar-
‘‘Substantially vested’’ means the person is reasonable and for services performed, ket value of the care provided is a reasona-
can transfer the property and is not subject the payment will not be denied as a deduc- ble estimate of the amount the employee
to a risk of forfeiture; that is, the recipient is tion merely because the corporation has a would pay for care of the type and quality you
Chapter 9 EMPLOYEES’ PAY Page 37
furnished. Any amount over the limit is in- law. Generally, qualified benefits include ac- condition of their employment.
cluded in the employee’s income in box 1 of cident or health plans, dependent care as- This means that they must accept the
Form W–2. This excess is subject to income sistance benefits, and group term life insur- lodging in order for them to properly
tax withholding and FICA and FUTA taxes. ance. The costs of group term life insurance perform their duties.
For information on the requirements for in excess of $50,000 and employer-provided
dependent care assistance programs, see dependent group term life insurance are
chapter 5 in Publication 535. considered qualified benefits. If the employees have a choice of either
receiving additional pay or receiving meals
or lodging, you treat the value of the meals or
Nondiscrimination rules. If, in any plan
Supplemental year, your cafeteria plan discriminates in
lodging as income to your employees.
For more information, see chapter 3 in
Unemployment Benefits favor of certain employees as to eligibility to Publication 535.
participate in the plan or plan contributions
You can deduct costs you pay to a welfare or benefits, these employees are taxed on
benefit fund that provides supplemental un- the amount of the taxable benefits that could
employment benefits for your employees if have been elected.
the costs are ordinary and necessary ex- Exclusion of
penses incurred in a trade or business or for
the production of income. Your deduction More information. For more information on Fringe Benefits
cannot be more than the fund’s qualified cafeteria plans and the reporting require-
cost for the tax year. ments, see chapter 5 in Publication 535.
You can exclude certain fringe benefits you
These amounts are deducted on the Em- provide an employee from the employee’s
ployee benefit programs line on your busi- income. If the fringe benefits are excludable,
ness tax return or schedule. the benefits are not subject to income tax
Meals and Lodging withholding, social security and Medicare
taxes (FICA), or federal unemployment tax
Welfare benefit fund. A welfare benefit Furnished to (FUTA). Excludable fringe benefits include:
fund is any fund that is part of your plan
through which you provide welfare benefits Employees
to employees or their beneficiaries. 1) No-additional-cost service.
You can usually deduct the costs of furnish-
ing meals and lodging to your employees if 2) Qualified employee discount.
More information. For more information the expense is an ordinary and necessary
and the definition of a fund’s qualified cost, business expense. You can usually deduct
see chapter 5 in Publication 535. only 50% of the cost of food or beverages 3) Working condition fringe.
you furnish.
If the meals and lodging meet the three 4) De minimis (minimal) fringe.
Cafeteria Plans rules for exclusion, described next, their
value is not included in the income of your 5) Qualified transportation fringe.
You can deduct your contributions to a cafe- employees. However, your deduction may
teria plan on the Employee benefit programs be subject to a limit. See chapter 15.
line of your tax return or schedule. If the value of the meals and lodging is 6) Qualified moving expense
Cafeteria plans, including flexible spend- not included in income, it is not subject to so- reimbursement.
ing arrangements, are written plans that al- cial security, Medicare, or FUTA tax or in-
low your employees to choose among two or come tax withholding. 7) Certain athletic facilities.
more benefits consisting of cash and quali- If you have deducted the cost of these
fied benefits. items elsewhere on your tax return (for ex-
Generally, a plan that provides for de- ample, as part of the cost of goods sold), you The value of meals you provide to your
ferred compensation is not a cafeteria plan. cannot deduct their cost again as pay for employees at an eating facility operated by
However, certain profit-sharing or stock bo- employees. you on or near your business premises is a
nus plans, and certain life insurance plans de minimis fringe only if the annual revenue
maintained by educational institutions, can from the facility equals or exceeds the direct
be offered through a cafeteria plan even Rules for Exclusion operating costs of the facility.
though they provide for deferred You can exclude from your employees’
compensation. Meals and lodging you furnish to your em- income the value of an on-premises gym or
The fact that cash or certain taxable ben- ployees must meet the following rules before other athletic facility you provide and oper-
efits may be chosen under the plan does not you can exclude their value from the employ- ate if substantially all the use during the cal-
cause an employee to be treated as having ees’ income. endar year is by your employees, their
received the cash or taxable benefit. spouses, and their dependent children.
Rule 1. The meals or lodging must be You can also exclude from your employ-
furnished on your business ees’ income any reimbursements or pay-
Qualified benefits. A cafeteria plan may of- premises. ments you make for qualified moving
fer any qualified benefit other than scholar- expenses.
ships and fellowship grants, educational as- Rule 2. The meals or lodging must be Certain nondiscrimination requirements
sistance, and, generally, the fringe benefits furnished for your convenience. apply to a no-additional-cost service, quali-
discussed in chapter 4 of Publication 535. fied employee discount, and an employer-
Qualified benefits include any other benefits Rule 3. In the case of lodging (but not operated eating facility.
your employees are allowed to exclude from meals), the employees must be re- For more information on fringe benefits,
income because of specific provisions of the quired to accept the lodging as a see chapter 4 in Publication 535.
Page 38 Chapter 9 EMPLOYEES’ PAY
Topics ● How contributions to the plan and benefits
This chapter discusses: under the plan are to be determined, and
10. ● Qualified plans ● How much of an employee’s interest in the
plan must be guaranteed (vested).
● Kinds of qualified plans
Retirement ● Plans for the self-employed For more information, get Publication 560.
Plans ● Keogh plans
● Simplified employee pensions (SEPs) Nondiscrimination rules. To prevent dis-
crimination in a plan caused by using sepa-
● Salary reduction arrangements rate businesses (and separate plans), all
● Nonqualified plans employees of certain related employers are
treated as if employed by a single employer.
Introduction ● Individual retirement arrangements
(IRAs)
For example, employees of commonly con-
trolled businesses or affiliated service
Retirement plans are savings plans that of- groups are treated as working for a single
fer you tax advantages to set aside money Useful Items employer.
for your own and your employees’ You may want to see:
retirement. More than one job. If you are self-em-
In general, a sole proprietor or a part- Publication ployed and also work for someone else, you
ner also is considered an employee for □ 533 Self-Employment Tax can participate in retirement plans for both
purposes of participating in a retirement jobs. Generally, your participation in a retire-
□ 560 Retirement Plans for the Self-
plan. ment plan for one job does not affect your
Employed
participation in a plan for the other job. How-
□ 590 Individual Retirement ever, if you have an IRA, you might not be
Funding the plan. A retirement plan you es- Arrangements (IRAs) permitted to deduct some or all of your IRA
tablish as an employer can be funded en- contributions.
tirely by your contributions or by a mix of your □ 15 Employer’s Tax Guide (Circular E)
Your deduction for IRA contributions
contributions and employee contributions. might be limited if you also participate in a
Employee contributions do not have to sat- Form (and Instructions)
SEP-IRA. See Publication 560. In addition,
isfy the minimum funding requirements for □ W–2 Wage and Tax Statement your IRA deduction might be limited because
your plan. For example, a retirement plan
□ 5305–SEP Simplified Employee you (or your spouse) are covered by an em-
can require after-tax employee contributions ployer’s retirement plan and your income is
Pension-Individual Retirement
that by themselves do not meet the minimum Accounts Contribution Agreement above a certain amount. See Publication
funding requirements. Employee contribu- 590.
tions can be mandatory or voluntary. □ 5305A–SEP Salary Reduction and
A plan can allow your employees to make Other Elective Simplified Employee
elective deferrals, although they are con- Pension-Individual Retirement Kinds of Qualified Plans
sidered employer contributions. This al- Accounts Contribution Agreement There are two basic kinds of qualified retire-
lows employees to elect to have you contrib- □ 5500–EZ Annual Return of One- ment plans: defined contribution plans and
ute part of their current compensation (pay) Participant (Owners and Their defined benefit plans.
to a retirement plan. Only the remaining por- Spouses) Retirement Plan
tion of their pay is currently taxable. The in- Defined Contribution Plans
come tax on the contributed pay (and earn-
These are plans that provide for a separate
ings on it) is deferred .
Employer contributions. Your contri- Qualified Plans account for each person covered by the
plan. Benefits are based only on amounts
butions as an employer to an employer- A qualified retirement plan is a written contributed to or allocated to each account.
sponsored retirement plan generally are de- plan that you, as an employer, can establish There are three types of defined contri-
ductible as discussed later under Deduction for the exclusive benefit of your employees bution plans: profit-sharing plans, stock bo-
Limits. and their beneficiaries. nus plans, and money purchase pension
Contributions to the plan may be made plans.
by you or by both you and your employees. If
Employer contributions that must be cap-
your plan meets the qualification require-
italized. You cannot currently deduct your Profit-sharing plan. This is a plan that lets
ments, you generally can deduct your contri-
employer contributions to a retirement plan, your employees or their beneficiaries share
butions to the plan when you make them, ex-
or any other expenses, that you must capital- in the profits of your business. The plan must
cept for any amount you must capitalize. For
ize (include in the basis of certain property or have a definite formula for allocating the
more information, get Publication 560.
in inventory costs). See chapters 5 and 7. contributions to the plan among the partici-
Your employees generally are not taxed
pating employees and for distributing the
on your contributions or increases in the
funds in the plan.
Kinds of plans. Retirement plans are either: plan’s assets until they are distributed to
them. However, certain loans made from
● Qualified plans (including retirement plans qualified employer plans are treated as taxa- Stock bonus plan. The benefits in this plan
for the self-employed, such as HR–10 (Ke- ble distributions. For more information, get are similar to those of a profit-sharing plan.
Publication 575. Benefits are payable in the form of the com-
ogh) plans and simplified employee pen-
pany’s stock. Only a corporation can set up a
sions (SEPs)), or
Qualification rules. To be a qualified plan, stock bonus plan.
● Nonqualified plans. the plan must meet many requirements.
Among these are rules concerning: Money purchase pension plan. Under this
plan, your contributions are a stated amount,
Also, in general, individuals who are em- ● Who must be covered by the plan, or are based on a stated formula that is not
ployed can set up and contribute to individ- ● How contributions to the plan are to be subject to your discretion. For example, your
ual retirement arrangements (IRAs). invested, formula could be 10% of each participating
Chapter 10 RETIREMENT PLANS Page 39
Table 10-1. Key Retirement Plan Rules
Type
of Last Date for When To Begin
Plan Contribution Maximum Contribution Distributions1
IRA Due date of IRA owner’s Smaller of $2,000 or taxable compensation April 1 of year after year IRA
income tax return (NOT owner reaches age 701/ 2
including extensions)
SEP– Due date of employer’s Smaller of $30,000 or 15%2 of participant’s taxable April 1 of year after year
IRA return (Plus extensions) compensation3 participant reaches age 701/ 2
Keogh Due date of employer’s Defined Contribution Plans Generally, April 1 of year
return (plus extensions).4 after year participant
Employee Self-Employed Individual reaches age 701/ 26
Money Purchase–Smaller Money Purchase–Smaller
of $30,000 or 25% of of $30,000 or 20% of self-
employee’s taxable employed participant’s
compensation taxable compensation5
Profit-Sharing–Smaller of Profit-Sharing–Smaller of
$30,000 or 15% of $30,000 or 13.0435% of
employee’s taxable self-employed participant’s
compensation taxable compensation5
Defined Benefit Plans
Amount needed to provide an annual retirement benefit no
larger than the smaller of $120,000 or 100% of the
participant’s average taxable compensation for his or her
highest 3 consecutive years
1
Distributions of at least the required minimum amount must be made each year if the entire balance is not distributed.
2
13.0435% of the self-employed participant’s taxable compensation before adjustment for this contribution.
3
Contributions are made to each participant’s IRA (SEP-IRA) including that of any self-employed participant.
4
The employer must set up the plan by the end of the employer’s tax year.
5
Compensation is before adjustment for this contribution.
6
If the participant reached age 701/ 2 before 1988, distributions must begin by the year he or she retires.
employee’s compensation. Your contribu- more information, get Publication 1380, User Qualified Plans, earlier. These plans gener-
tions to the plan are not based on your Fees. ally are called Keogh or HR–10 plans. You
profits. also can set up a less complicated tax-ad-
Master and prototype plans. It may be vantaged retirement plan. See Simplified
Defined Benefit Plans easier for you to adopt an existing IRS-ap- Employee Pension (SEP), later.
These are any plans that are not defined proved master or prototype retirement plan
than to set up your own original plan. Master
contribution plans. In general, a qualified de-
and prototype plans can be provided by the
Keogh Plans
fined benefit plan must provide for set bene-
following sponsoring organizations: Only a sole proprietor or a partnership (but
fits. Your contributions to the plan are based
not a partner) can set up a Keogh plan. For
on actuarial assumptions. You may need ● Trade or professional organizations, plan purposes, a self-employed person is
continuing professional help to have a de- ● Banks (including some savings and loan both an employer and an employee. It is not
fined benefit plan.
associations and federally insured credit necessary to have employees besides your-
unions), self to set up a Keogh plan. The plan must be
Plan Approval for the exclusive benefit of employees or
● Insurance companies, or
The Internal Revenue Service (IRS) will is- their beneficiaries. You generally can deduct
sue a determination or opinion letter regard- ● Mutual funds. contributions to the plan. Contributions are
ing a plan’s qualification. The determination not taxed to your employees until plan bene-
or opinion of the IRS will be based on how Adoption of a master or prototype plan does fits are distributed to them.
the plan is written, not on how it operates. not mean that your plan is automatically
You are not required to request a deter- qualified. It must still meet all of the qualifica-
Deduction Limits
mination or opinion letter to get all the tax tion requirements stated in the tax law.
benefits of a plan. But, if your plan does not The limit on your deduction for your contribu-
have a determination letter, you may want to tions to a Keogh plan depends on the kind of
request one to ensure that your plan meets plan you have.
the requirements for tax benefits. Retirement Plans for
Because requesting a determination,
opinion, or ruling letter can be complex, you
the Self-Employed Defined contribution plans. The deduc-
tion limit for a defined contribution plan de-
may need professional help. Also, the IRS If you are a self-employed person, you can pends on whether it is a profit-sharing plan or
charges a fee for issuing these letters. For set up certain qualified retirement plans. See a money purchase pension plan.
Page 40 Chapter 10 RETIREMENT PLANS
Profit-sharing plan. Your deduction for that income) other than foreign earned in- for contributions for yourself by completing
contributions to a profit-sharing plan cannot come and foreign housing cost amounts. the following steps:
be more than 15% of the compensation Your net earnings are your business
from the business paid (or accrued) during gross income minus allowable deductions
the year to the common-law employees par- from that business. Allowable deductions in- Deduction Worksheet for Self-Employed
ticipating in the plan. You must reduce this clude contributions to the plan for your com-
15% limit in figuring the deduction for contri- mon-law employees along with your other
Step 1
butions you make for your own account. See business expenses. If you are a partner,
Enter the contribution rate shown
Deduction of contributions for yourself, later. other than a limited partner, your net earn-
in line (3), above . . . . . . . . . . . . . . . . . . .
Money purchase pension plan. Your ings include your distributive share of the
Step 2
deduction for contributions to a money partnership income or loss (other than sepa-
Enter your net earnings (net profit)
purchase pension plan is limited to 25% of rately computed items such as capital gains
from line 3, Schedule C–EZ (Form
the compensation from the business paid (or and losses) and any guaranteed payments
1040), line 31, Schedule C (Form
accrued) during the year to participating you received from the partnership. If you are
1040), line 36, Schedule F (Form
common-law employees. You must reduce a limited partner, your net earnings include 1040), or line 15a, Schedule K–1
this 25% limit in figuring the deduction for only guaranteed payments you receive for (Form 1065) . . . . . . . . . . . . . . . . . . . . . . . . $
contributions you make for yourself, as dis- services rendered to or for the partnership.
For more information, see Partners under Step 3
cussed later.
Self-Employment Income, in Publication Enter your deduction for self-
533. employment tax from line 25, Form
Defined benefit plans. The deduction for 1040 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
Adjustments. You must reduce your net
contributions to a defined benefit plan is earnings by the income tax deduction you Step 4
based on actuarial assumptions and compu- are allowed for one-half of the self-employ- Subtract step 3 from step 2 and
tations. Consequently, an actuary must fig- ment tax. Also, net earnings must be re- enter the result . . . . . . . . . . . . . . . . . . . . . $
ure your deduction limit. duced by the deduction for contributions you Step 5
make for yourself. This reduction is made in- Multiply step 4 by step 1 and enter
directly, as explained next. the result . . . . . . . . . . . . . . . . . . . . . . . . . . . $
Note. In figuring the deduction for contri- Net earnings reduced by adjusting Step 6
butions, you cannot take into account any contribution rate. You must reduce your Multiply $150,000 by your plan
contributions or benefits that exceed the lim- net earnings by the deduction for contribu- contribution rate. Enter the result
its discussed under Limits on Contributions tions for yourself. The deduction and the net but not more than $30,000 . . . . . . . . $
and Benefits in Publication 560. earnings depend on each other. You can
Step 7
make the adjustment to your net earnings in-
Enter the smaller of step 5 or step
The deduction limit for contributions to a directly by reducing the contribution rate
6. This is your maximum
defined benefit plan may be greater than called for in the plan and using the reduced
deductible contribution. Enter
the defined contribution plan limits just de- rate to figure your maximum deduction for
your deduction on line 27, Form
scribed, but actuarial calculations are contributions for yourself.
1040 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
needed to determine the amount. For more Annual compensation limit. You gen-
information about these plans, see Kinds of erally cannot take into account more than
Plans in Publication 560. $150,000 of your compensation in figuring
Example. You are a sole proprietor and
your contribution to a defined contribution
have employees. The terms of your plan pro-
plan.
Deduction of contributions for yourself. vide that you contribute 101/ 2% (.105) of your
To take a deduction for contributions you compensation, and 101/ 2% of your common-
make for yourself to a plan, you must have Figuring your deduction. Use the follow- law employees’ compensation. Your net
net earnings from the trade or business for ing worksheet to find the reduced contribu- earnings from line 31, Schedule C (Form
which the plan was established. tion rate for yourself. Make no reduction to 1040) are $200,000. In figuring this amount,
Limit on deduction. If the Keogh plan is the contribution rate for any common-law you deducted your common-law employees’
a profit-sharing plan, your deduction for employees. pay of $100,000 and contributions for them
yourself is limited to the smaller of $30,000 of $10,500 (101/ 2% x $100,000). You figure
or 13.0435% (15% reduced, as discussed your self-employed rate and maximum de-
below) of your net earnings from the trade or Rate Worksheet for Self-Employed
duction for employer contributions for your
business that has the plan. If the plan is a benefit as follows:
money purchase pension plan, the deduc-
1) Plan contribution rate as a decimal
tion is limited to the smaller of $30,000 or
(for example, 101/ 2% would be Rate Worksheet for Self-Employed
20% (25% reduced, as discussed below) of
0.105) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
your net earnings.
Net earnings. Your net earnings must 2) Rate in line 1 plus one (for
1) Plan contribution rate as a decimal
be from self-employment in a trade or busi- example, 0.105 plus one would be
(for example, 101/ 2% would be
ness in which your personal services are a 1.105) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
0.105) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.105
material income-producing factor. If you are 3) Self-employed rate as a decimal 2) Rate in line 1 plus one, (for
a partner who only contributed capital, and (divide line 1 by line 2) . . . . . . . . . . . . . example, 0.105 plus one would be
who did not perform personal services, you 1.105) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.105
cannot participate in the partnership’s plan.
3) Self-employed rate as a decimal
Your net earnings do not take into account Now that you have your self-employed
(divide line 1 by line 2) . . . . . . . . . . . . . 0.0950
tax-exempt income (or deductions related to rate, you can figure your maximum deduction
Chapter 10 RETIREMENT PLANS Page 41
Deduction Worksheet for Self-employed employee. For more information, get Publi- SEP and profit-sharing plans. If you also
cation 560. contributed to a qualified profit-sharing plan,
Step 1 You may be able to use Form 5305–SEP you must reduce the 15% deductible limit for
Enter the contribution rate in setting up your SEP. See the Form 5305– that plan by the allowable deduction for con-
shown on line (3), above . . . . . . . . 0.0950 SEP sample shown in this chapter. tributions to the SEP-IRAs of those partici-
Step 2 pating in the profit-sharing plan.
Enter your net earnings (net Contribution limits. Contributions you
profit) from line 3, Schedule C– make for a year to a common-law employ- SEP and other qualified plans. If you also
EZ (Form 1040), line 31, ee’s SEP-IRA cannot exceed the smaller of contributed to any other type of qualified
Schedule C (Form 1040), line 36, 15% of the employee’s compensation or plan, treat the SEP as a separate profit-shar-
Schedule F (Form 1040), or line $30,000. Compensation, for this purpose, ing plan for purposes of applying the overall
15a, Schedule K–1 (Form 1065) $ 200,000 does not include employer contributions to 25% deduction limit described in section
Step 3 the SEP. 404(h)(3) of the Internal Revenue Code.
Enter your deduction for self- Annual compensation limit. You gen-
employment tax from line 25, erally cannot consider the part of compensa- Employee contributions. Participants can
Form 1040 . . . . . . . . . . . . . . . . . . . . . . . $ 6,473 tion of an employee that is over $150,000 also make contributions of up to $2,000 to
when you figure your contributions limit for their SEP-IRAs independent of your SEP
Step 4 that employee. contributions. The portion of the contribu-
Subtract step 3 from step 2 and
tions that is deductible may be reduced or
enter the result . . . . . . . . . . . . . . . . . . $ 193,527 Note. For employees in a collective bar- eliminated because the participant is cov-
Step 5 gaining unit for which the $150,000 limit is ered by an employer retirement plan (the
Multiply step 4 by step 1 and not effective, the compensation limit is SEP plan). See Publication 590 for details.
enter the result . . . . . . . . . . . . . . . . . . $ 18,385 $245,000.
Step 6 More than one plan. If you also contrib- Salary Reduction Arrangement
Multiply $150,000 by your plan ute to a defined contribution retirement plan, A SEP can include a salary reduction (elec-
contribution rate. Enter the result annual additions to an account are limited to tive deferral) arrangement. Under the ar-
but not more than $30,000 . . . . . . $ 15,750 the lesser of (1) $30,000 or (2) 25% of the rangement, employees can elect to have
Step 7 participant’s compensation. When you figure you contribute part of their pay to their SEP-
Enter the smaller of step 5 or these limits, your contributions to more than IRAs. The income tax on the part contributed
step 6. This is your maximum one such plan must be added. Since a SEP is deferred. This choice is called an elective
deductible contribution. Enter is considered a defined contribution plan for deferral, which remains tax free until distrib-
your deduction on line 27, Form purposes of these limits, your contributions uted (withdrawn). This election is available
1040. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,750 to a SEP must be added to your contribu- only if:
tions to defined contribution plans. ● At least 50% of your employees eligible to
Reporting on Form W–2. Do not in- participate choose the salary reduction
When to make contributions. In order to clude SEP contributions on Form W–2, arrangement,
take a deduction for contributions for a par- Wage and Tax Statement, unless there are
contributions over the limit that applies or
● You had no more than 25 employees who
ticular year, you must make the contributions were eligible to participate in the SEP (or
not later than the due date, plus extensions, there are contributions under a salary reduc-
tion arrangement. would have been eligible to participate if
of your return for that year. you had maintained a SEP) at any time
Contributions for yourself. The annual
limits on your contributions to a common-law during the preceding year, and
Additional information. Additional infor-
employee’s SEP-IRA also apply to contribu- ● The deferral each year by each eligible
mation on retirement plans for the self-em-
tions you make to your own SEP-IRA. How- highly compensated employee (as de-
ployed and on the reporting forms that must
ever, special rules apply when you figure fined in Publication 560) as a percentage
be filed for these plans can be found in Publi-
your maximum deductible contribution. See of pay (deferral percentage) is no more
cation 560.
Deduction of contributions for yourself, later. than 125% of the average deferral per-
centage (ADP) of all nonhighly compen-
Simplified Employee Deduction limits. The most you can deduct sated employees eligible to participate
Pension (SEP) for employer contributions for common-law (the ADP test). You generally cannot con-
employees is 15% of the compensation paid sider compensation of an employee in ex-
A simplified employee pension (SEP) is a to them during the year from the business cess of $150,000 in figuring an employ-
written plan that allows you to make deducti- that has the plan. ee’s deferral percentage.
ble contributions toward your own and your Deduction of contributions for your-
employees’ retirement without getting in- self. When figuring the deduction for em- Note. For employees in a collective bar-
volved in more complex retirement plans. A ployer contributions made to your own SEP- gaining unit covered by a SEP for which the
corporation can also have a SEP and make IRA, compensation is your net earnings from $150,000 limit is not effective, the compen-
deductible contributions toward its employ- self-employment, which takes into account: sation limit is $245,000.
ees’ retirement. But some advantages avail-
able to Keogh and other qualified plans, 1) The deduction allowed to you for one-
such as the special treatment that may apply half of the self-employment tax, and Limits on deferrals. In general, the total in-
to lump-sum distributions, do not apply to 2) The deduction for contributions on be- come an employee can defer under a salary
SEPs. half of yourself to the plan. reduction arrangement included in a SEP
Under a SEP, you make the contributions and certain other elective deferral arrange-
to an individual retirement arrangement The deduction amount for (2), above, and ments for 1995 is limited to the lesser of
(called a SEP-IRA in this chapter), which is your compensation (net earnings) are each 15% of compensation or $9,240. This limit
owned by you or your common-law dependent on the other. For this reason, the applies only to the amounts that represent a
employee. deduction amount for (2) is figured indirectly reduction from the employee’s pay, not to
SEP-IRAs are set up for, at a minimum, by reducing the contribution rate called for in any contributions from employer funds.
each qualifying employee. A SEP-IRA may your plan. This is done by using the Rate
have to be set up for a leased employee, Worksheet for Self-Employed, shown earlier Employment taxes. Elective deferrals, not
but need not be set up for an excludable in the chapter. exceeding the ADP test, are not subject to
Page 42 Chapter 10 RETIREMENT PLANS
Chapter 10 RETIREMENT PLANS Page 43
income tax in the year of deferral, but are in- employee must include those amounts in shown in box 1 (wages, tips, other compen-
cluded in wages for social security, Medi- gross income for the tax year in which you sation) of Form W–2, provided that amount is
care, and unemployment tax purposes. make them. This rule also applies if the em- reduced by any amount shown in box 11
ployee’s interest is not subject to a substan- (nonqualified plans).
Reporting SEP Contributions on tial risk of forfeiture (that is, there is not much Self-employed. If you are self-em-
Form W–2 of a risk that the employee will lose his or her ployed (a sole proprietor or partner), com-
Your SEP contributions are excluded from interest) when you make contributions or pay pensation is the net earnings of your trade or
your employees’ income. Unless there are premiums for that employee. business (self-employment income) reduced
contributions above the limit that applies, or by the deduction for contributions on your
unless there are contributions under a salary behalf to retirement plans and the deduction
reduction arrangement, do not include these Nontransferable interest. If, when you allowed for one-half of your self-employment
contributions in your employees’ wages on make the contributions, the employee’s in- tax.
Form W–2, for income, social security, or terest in the trust or in the value of the annu- Compensation does not include:
Medicare tax purposes. Your SEP contribu- ity contract is not transferable and is subject
tions under a salary reduction arrange- to a substantial risk of forfeiture, the em- ● Income received from property, such as
ment are included in your employees’ Form ployee does not include that interest in gross
rental, interest, or dividend income, or
W–2 wages for social security and Medicare income until the tax year in which the interest
tax purposes only. becomes transferable or is no longer subject ● Any amounts received as a pension or an-
Example. In 1995 Jim chooses to have to a substantial risk of forfeiture.
nuity, or as deferred compensation.
$4,500 taken out of his pay to fund employer
contributions to his SEP-IRA. His compensa-
tion for the year is $30,000. On Jim’s Form Foreign income. Foreign earned in-
W–2, his employer will show total wages of
$25,500 ($30,000 minus $4,500) for income
Individual Retirement come and other amounts that are excluded
from gross income are not compensation for
tax and $30,000 for social security and Medi- Arrangements (IRAs) IRA purposes.
care wages. Jim will report $25,500 as
wages on his tax return.
You can set up and make contributions to an
For more information on employer with- Contributions. The most you can contrib-
individual retirement arrangement (IRA) if
holding requirements, get Publication 15. ute for any year to your IRA is the smaller of:
you received taxable compensation during
For more information on SEPs, see Publi-
the year and have not reached age 70 1/ 2 by
cation 560.
the end of the year. You can have an IRA ● $2,000, or
whether or not you are covered by any other
retirement plan. However, you may not be ● Your taxable compensation.
Nonqualified Plans able to deduct any or some of your contribu-
You can deduct contributions made to a non- tions if you or your spouse is covered by an
employer’s retirement plan. Deductible and nondeductible contribu-
exempt trust or premiums paid under a non- tions. Generally, you can take a deduction
qualified annuity plan. Your employees gen-
for the contributions you are allowed to
erally must include the contributions or
Compensation. Compensation includes make to your IRA. However, if you or your
premiums in their gross income.
taxable wages, salaries, commissions, bo- spouse is covered by an employer retire-
Deduct your contributions to the plan in
nuses, tips, professional fees, self-employ- ment plan at any time during the year, your
the tax year in which any of your employees
must include an amount of the contributions ment income (subject to certain adjust- IRA deduction may be reduced or elimi-
in their gross income. You can deduct contri- ments, discussed below, and providing your nated, depending on your filing status and
butions only if you maintain separate ac- personal services are a material income-pro- the amount of your income. Whether or not
counts for each participating employee. ducing factor), other amounts received for your allowable contributions are deductible,
personal services, and taxable alimony and you can choose to make nondeductible con-
Transferable interest. When an employ- separate maintenance payments. tributions to your IRA. For details on these
ee’s interest in your contributions or premi- Employee. If you are an employee, com- and other rules, as well as general informa-
ums for that employee is transferable, the pensation includes any amount properly tion on IRAs, see Publication 590.
Page 44 Chapter 10 RETIREMENT PLANS
deductible in the year paid or accrued. If you Leveraged leases. These transactions
pay rent in advance, you can deduct only the may be considered leases. Leveraged
11. amount that applies to your use of the rented leases generally involve three parties: a les-
property during the tax year. The balance sor, a lessee, and a lender to the lessor.
Rent Expense can be deducted only over the period to
which it applies.
Usually, the lease covers a large part of the
useful life of the leased property, and the les-
Example 1. In May 1995, you leased a see’s payments to the lessor are enough to
building for 5 years, beginning July 1, 1995, cover the lessor’s payments to the lender.
and ending June 30, 2000. According to the If you plan to take part in what appears to
Introduction terms of the lease, your rent is $12,000 per be a leveraged lease, you may want to get an
year. You paid the first year’s rent ($12,000) advance ruling. The following Revenue Pro-
If you lease business property, you generally on June 30, 1995. On your income tax return
can deduct the rent you pay. You can also cedures contain the guidelines the IRS will
for calendar year 1995, you can deduct only use to determine if a leveraged lease is a
deduct certain other expenses as rent. If you $6,000 (6/12 × $12,000) for the rent that
lease a car for 30 days or more for use in lease for federal income tax purposes:
applies to 1995.
your business, see Leasing a Car in Publica- Revenue Procedure 75–21, 1975–1 C.B.
tion 917. If you lease business property and Example 2. In January 1995, you leased
715
incur a casualty loss on the leased property, property for 3 years for $6,000 a year. You
see Leased Property in chapter 25. paid the full $18,000 (3 × $6,000) during the Revenue Procedure 75–28, 1975–1 C.B.
first year of the lease. For 1995, you can de- 752
duct only $6,000, the part of the rent that ap-
Topics plies to 1995. You can deduct the balance Revenue Procedure 76–30, 1976–2 C.B.
This chapter discusses: 647
($12,000) over the remaining 2-year term of
● The definition of rent the lease, at $6,000 each year. Revenue Procedure 79–48, 1979–2 C.B.
● Taxes on leased property 529
Lease or purchase. There may be in-
● The cost of acquiring a lease
stances where it is necessary to determine if In general, the Revenue Procedures pro-
● Improvements by lessee your payments are for rent or for the
vide that, for advance ruling purposes only,
● Capitalizing rent expenses purchase of the property. You must first de-
the IRS will consider the lessor in a lever-
termine if your agreement is a lease or a con-
aged lease transaction to be the owner of
Useful Items ditional sales contract. If, under the agree-
the property and the transaction to be a valid
You may want to see: ment, you acquired or will acquire title to or
equity in the property, the agreement should lease if all of the following apply:
Publication be treated as a conditional sales contract. 1) The lessor must maintain a minimum
Payments made under a conditional sales unconditional ‘‘at risk’’ investment (at
□ 538 Accounting Periods and Methods contract are not deductible as rent expense. least 20%) in the property during the en-
□ 946 How To Depreciate Property Whether the agreement is a conditional tire lease;
sales contract depends upon the intent of
□ 1375 Procedures For Issuing Rulings 2) The lessee may not have a contractual
the parties. Intent is determined based
upon the facts and circumstances existing at right to buy the property from the lessor
the time the agreement is made. at less than fair market value at the time
Rent Determining the intent. Generally, an the right is exercised;
agreement may be considered a conditional
Rent is any amount you pay for the use of 3) The lessee may not invest in the prop-
sales contract rather than a lease if any of
property that you do not own. You can gen- erty, except as provided by Revenue
the following is true:
erally deduct rent as an expense only if the Procedure 79–48;
rent is for property that you use in your trade 1) The agreement applies part of each
payment toward an equity interest that 4) The lessee may not lend any money to
or business. If you have or will receive equity
you will receive. the lessor to buy the property or guaran-
in or title to the property, the rent is not
tee the loan used to buy the property;
deductible. 2) You get title to the property upon the and
payment of a stated amount required
Unreasonable rent. You cannot take a under the contract. 5) The lessor must have a profit motive
rental deduction for rents that are unreason- apart from tax deductions, allowances,
3) The amount you pay to use the property
able. Ordinarily, the issue of reasonableness credits, and other tax attributes.
for a short period of time is a large part
of the rent will not arise unless you and the
of the amount you would pay to get title
lessor are related. Rent paid to a related per- The IRS will charge you a user fee for is-
to the property.
son is reasonable if it is the same amount suing a tax ruling. See Publication 1375 for
that would be paid to a stranger for use of 4) You pay much more than the current fair
more information.
the same property. A percentage rental is rental value for the property.
Leveraged leases of limited use prop-
reasonable if the rental paid is reasonable. 5) You have an option to buy the property erty. The IRS will not issue advance rulings
For a definition of related persons, see at a nominal price compared to the on leveraged leases of so-called limited use
chapter 3. value of the property at the time you property. Limited use property is property not
may take advantage of the option. De- expected to be either useful to or usable by a
Rent on a personal residence. If you rent termine this value at the time of the
rather than own a home and use part of your lessor at the end of the lease term except for
agreement. continued leasing or transfer to a member of
home as your place of business, you may be
able to deduct the rent you pay for that part, 6) You have an option to buy the property the lessee group. See Revenue Procedure
if you meet the requirements for business at a nominal price compared to the total 76–30 for examples of limited use property
use of your home. For more information, see amount you have to pay under the and property that is not limited use property.
Use Tests in Publication 587. lease. Special rules apply for leases of tangible
7) The lease designates some part of the property over $250,000. See Leases over
Rent paid in advance. Generally, rent paid payments as interest, or part of the pay- $250,000 in chapter 7 of Publication 535 for
in connection with your trade or business is ments is easy to recognize as interest. details.
Chapter 11 RENT EXPENSE Page 45
must amortize any amount you pay to ac- year will be $150 ($3,000 ÷ 20). You cannot
Taxes on Leased quire that lease over the remaining term of
the lease. For example, if you pay $10,000 to
deduct the $600 that you will actually pay
during each of the first 5 years as rent.
Property acquire an existing lease on a machine and
If you lease business property, you can de- there are 10 years remaining on the lease Commissions, bonuses, and fees. Com-
duct as additional rent any taxes that you with no option to renew, you can deduct missions, bonuses, fees, and other amounts
have to pay to or for the lessor. When you $1,000 each year. that you pay to obtain a lease on property
can deduct these taxes as additional rent de- The cost of acquiring a lease is not sub- you use in your business are capital costs.
pends on your accounting method. ject to the amortization rules on section 197 You must amortize these costs over the term
intangibles discussed in chapter 13. of the lease.
Cash method. If you use the cash method
of accounting, you can deduct the taxes as Option to renew. The term of the lease for Loss on merchandise and fixtures. If you
additional rent only for the tax year in which amortization will include all renewal options sell merchandise and fixtures that you
you pay them. (as well as any period for which the lessee bought solely to acquire a lease and you
and lessor reasonably expect the lease to be have a loss on the sale, the loss is a cost of
Accrual method. If you use an accrual renewed) if less than 75% of the cost is for acquiring the lease. You must capitalize the
method of accounting, you can deduct taxes the term of the lease remaining on the loss and amortize it over the remaining term
as additional rent for the tax year in which purchase date. In determining the term of of the lease.
you can determine: the lease remaining on the purchase date,
you do not include any period for which the
1) That you have a liability for taxes on the
lease may be renewed, extended, or contin-
leased property,
ued under an option exercisable by the Improvements by
2) How much the liability is, and lessee.
3) That economic performance occurred. Generally, allocation of the lease cost to Lessee
the original term and any option term is If you add buildings or make other perma-
The liability and amount of taxes are de- based on the facts and circumstances. This nent improvements to leased property, you
termined by state or local law, and also by allocation can be made using a present depreciate the cost of the improvements us-
the lease agreement. Economic perform- value computation. For more information, ing the modified accelerated cost recovery
ance occurs as you use the property. see section 1.178–1(b)(5) of the Income Tax system (MACRS). The property is depreci-
Example. Oak Corporation is a calendar Regulations. ated over its appropriate recovery period.
year taxpayer that uses an accrual method Example 1. You paid $10,000 to acquire You are not allowed to amortize the cost
of accounting. Oak leases land for use in its a lease with 20 years remaining on it and two over the remaining term of the lease.
business. Under local law, owners of real options to renew for 5 years each. Of this If you do not keep the improvements
property become liable (incur a lien on the cost, $7,000 was paid for the original lease when the lease is terminated, your gain or
property) for real estate taxes for the year on and $3,000 was applied to the renewal op- loss is based on your adjusted basis of the
January 1 of that year, but do not have to pay tions. Since $7,000 is less than 75% of the improvements at that time. For more infor-
these taxes until July 1 of the next year (18 total cost of the lease of $10,000, you must mation, see Publication 946.
months later). This means that property amortize the $10,000 over 30 years, the re-
owners become liable for 1995 real estate maining life of your present lease plus the Assignment of a lease. If a long-term
taxes on January 1, 1995, but do not have to periods for renewal. lessee makes permanent improvements to
pay them until July 1, 1996. Example 2. Assume the same facts as in leased land and later assigns all lease rights
Under the terms of the lease, Oak be- Example 1, except that the amount that ap- to you for money, and you pay rent required
comes liable for the real estate taxes when plies to the original lease was $8,000. You by the lease, the amount you pay for the as-
the tax bills are issued on July 1, 1996. Oak are allowed to amortize the entire $10,000 signment is a capital investment. If the rental
cannot deduct the real estate taxes for 1995 over the 20-year remaining life of the original value of the leased land increased since the
as additional rent until July 1, 1996. This is lease because the $8,000 cost of acquiring lease began, part of your capital investment
when Oak’s liability under the lease be- the original lease was not less than 75% of is for that increase in the rental value, and
comes fixed. the total cost of the lease. the balance is for your investment in the per-
If, according to the terms of the lease, manent improvements.
Oak is liable for the real estate taxes when The part that is for the increased rental
Cost of a modification agreement. If you
the owner of the property becomes liable for value of the leased land is a cost of acquiring
have to pay an additional ‘‘rent’’ amount
them on January 1, 1995, but does not have a lease, and you amortize it over the remain-
over part of the lease period in order to
to pay them until July 1, 1996, Oak will de- ing term of the lease. You can depreciate the
change certain provisions in your lease, you
duct the lessor’s real estate taxes as addi- part that is for your investment in the im-
must capitalize these payments and amor-
tional rent on its 1995 tax return. This is the provements as discussed earlier.
tize them over the remaining period of the
year in which Oak’s liability under the lease lease. You cannot deduct the payments as
becomes fixed. additional rent even if they are described as
rent in the agreement.
Capitalizing
Example. You are a calendar year tax-
Cost of Acquiring a payer and sign a 20-year lease to rent part of Rent Expenses
a building starting on January 1. However,
Lease before you occupy it, you decide that you re-
Under the uniform capitalization rules, you
have to capitalize direct costs and an alloca-
You may either enter into a new lease with ally need less space. The lessor agrees to
ble part of most indirect costs that benefit or
the lessor of the property or acquire an ex- reduce your rent from $7,000 to $6,000 per
are incurred because of production or resale
isting lease from another lessee. Very often year and to release the excess space from
activities.
when you acquire an existing lease from an- the original lease. In exchange, you agree to
You are subject to the uniform capitaliza-
other lessee, in addition to paying the rent on pay an additional rent amount of $3,000 pay-
tion rules if you:
the lease, you must pay the previous lessee able in 60 monthly installments of $50 each.
a sum of money to acquire that lease. You must capitalize the $3,000 and 1) Produce real or tangible personal prop-
If you acquire an existing lease on prop- amortize it over the 20-year term of the erty for use in a trade or business or an
erty or equipment for your business, you lease. Your amortization deduction each activity engaged in for profit,
Page 46 Chapter 11 RENT EXPENSE
2) Produce real or tangible personal prop- Example 1. You rent construction equip- tools. The rent you paid to occupy the facility
erty for sale to customers, or ment to build a storage facility. The rent you must be included in the cost of the tools you
3) Acquire property for resale. However, paid for the equipment must be capitalized produce.
this rule does not apply to personal as part of the cost of the building. You re-
property if your average annual gross cover your cost by claiming a deduction for More information. For more information,
receipts are not more than $10 million. depreciation on the building. see Uniform Capitalization Rules in Publica-
tion 538.
Indirect costs include amounts incurred Example 2. You rent space in a facility to
for rent of equipment, facilities, or land. conduct your business of manufacturing
Chapter 11 RENT EXPENSE Page 47
Topics Partial business use. If you use property for
This chapter discusses: business or investment purposes and also
12. ● Basic information on depreciation
for personal purposes, you can deduct only
depreciation based on the business use and
● The section 179 deduction
Depreciation ● The Modified Accelerated Cost
the use for the production of income. For ex-
ample, if you use your car both for business
Recovery System (MACRS) and personal transportation, determine what
percentage of its use is for business and de-
● Listed property rules preciate only the business percentage part
● Form 4562 of its cost.
Important Change
for 1995 Useful Items Passenger automobiles. There are dollar
You may want to see: limits on the amount of the depreciation de-
Limits on depreciation for business cars. ductions you can claim for passenger auto-
The total section 179 deduction and depreci- Publication mobiles. There are also other limits on the
ation you can take on a car that you use in depreciation you can claim for passenger
□ 534 Depreciating Property Placed in
your business and first place in service in automobiles not used more than 50% in a
Service Before 1987
1995 is $3,060. Your depreciation cannot ex- qualified business use. A similar limit applies
ceed $4,900 for the second year of recovery, □ 538 Accounting Periods and Methods to lessees of leased cars. See Listed Prop-
$2,950 for the third year of recovery, and □ 551 Basis of Assets erty, later.
$1,775 for each later tax year. See Passen-
□ 917 Business Use of a Car
ger automobiles, later. Idle property. You must claim a deduction
□ 946 How To Depreciate Property for depreciation on property used in your
General asset account. You can elect to business that is temporarily idle. For exam-
place assets subject to MACRS in one or Form (and Instructions) ple, if you stop using a piece of machinery
more general asset accounts. After you have □ 4562 Depreciation and Amortization because there is a temporary lack of a mar-
established a general asset account, figure ket for a product made with the machinery,
□ 4797 Sales of Business Property
depreciation on the entire account by using the machinery is still treated as used in your
the applicable depreciation method, recov- □ 6251 Alternative Minimum Tax— business for federal income tax purposes.
ery period, and convention for the assets in Individuals
the account. Intangible Property
For more information, see General Asset Intangible property is generally any property
Account later.
General Information that has value and cannot be seen or
touched. It and includes property such as a
The first part of the chapter provides you copyright, patent, or franchise.
with information on property that can and
Introduction cannot be depreciated, when depreciation
Generally, if acquired prior to August 11,
1993 (or July 26, 1991, if elected), intangi-
begins and ends, and when to claim
If you buy certain property for use in your ble property was depreciable only if you
depreciation.
trade or business that has a useful life of could determine a useful life for it. Some ex-
more than 1 year, you can claim a limited amples of these depreciable and nondepre-
amount of the cost as a section 179 deduc- What Can Be Depreciated ciable intangible properties are discussed
tion. You must spread the remainder of the For property to be depreciable, it must first next. However, if you acquired an intangible
cost of this property over more than 1 year meet all of the following basic requirements: property after August 10, 1993 (July 25,
and claim depreciation deductions over the 1) The property must be used in business 1991, if elected), it may qualify for amortiza-
recovery period of the property. You can or held for the production of income. tion as a section 197 intangible asset. For in-
take depreciation deductions only on prop- formation on section 197 intangible assets,
erty that is used in your trade or business or 2) The property must have a determinable see chapter 13.
for the production of income. useful life and that life must be longer
MACRS is the depreciation system that than one year.
Patents and copyrights. Unless you must
applies to property placed in service after 3) The property must be something that amortize the costs of a patent or copyright
1986. If you need information on the depreci- wears out, decays, gets used up, be- (as explained in chapter 13), you can recover
ation methods for property placed in service comes obsolete, or loses value from the costs through depreciation. If you can
before 1987, see Publication 534. natural causes. depreciate the cost of a patent or copyright,
Generally, if you sell, exchange, or invol- use the straight line method over the useful
untarily convert depreciable property, and a Depreciable property may be either tan- life. The useful life is the life granted by the
gain (profit) is realized, all or part of the gain gible or intangible. government for the patent or copyright. If it
may be ordinary income. See Chapter 23. becomes valueless in any year before its
Two other methods for recovering the Tangible Property useful life expires, you can deduct in full for
cost of property, amortization and depletion, Tangible property is any property that can be that year any remaining cost or other basis
permit deductions similar to those allowed seen or touched. Tangible property includes you have not yet depreciated.
by depreciation. Amortization is a method real and personal property. Personal prop- Patents and copyrights subject to
that permits you to deduct certain capital ex- erty is property such as machinery or equip- amortization. If you acquired patents and
penditures in a way similar to depreciation. ment that is not real estate. Real property is copyrights as part of the acquisition of a sub-
Depletion permits the owner of an eco- land and generally anything that is erected stantial portion of a business after August
nomic interest in mineral deposits, oil wells, on, growing on, or attached to land. How- 10, 1993 (after July 25, 1991, if elected), you
gas wells, geothermal deposits, or standing ever, land itself is never depreciable. generally have to amortize the cost as dis-
timber to deduct the cost of the economic in- You can deduct depreciation on tangible cussed in chapter 13. If the patent or copy-
terest over the economic life of the property. property only if it can wear out, decay, lose right is not acquired as part of an acquisition
Depletion and amortization are explained in value from natural causes, be used up, or if it of a substantial portion of a business, depre-
Chapter 13. becomes obsolete. ciate the cost as discussed above.
Page 48 Chapter 12 DEPRECIATION
Agreement not to compete. An agree- software was included in the price of com- Property placed in service and disposed
ment not to compete is an agreement by the puter hardware and the software cost was of in the same year. You cannot deduct de-
seller of a business not to compete with the not separately stated, you treat the entire preciation on property placed in service and
buyer. The agreement may restrict competi- amount as the cost of the hardware and de- disposed of in the same taxable year. When
tion for an agreed upon period of time, within preciate it under MACRS as discussed later. property is considered placed in service is
an agreed upon area, or for a combination of If the cost of the software was separately explained later.
both. stated, you can depreciate the cost using the
Generally, if you bought a business straight line method over 5 years (or any Inventory. You can never depreciate inven-
before August 11, 1993, and part of its price shorter life you can establish). tory. Inventory is any property that is held pri-
is for an agreement not to compete for a Software acquired after August 10, marily for sale to customers in the ordinary
fixed number of years, the agreement is de- 1993. If you acquire software after August course of business.
preciable property. However, because good- 10, 1993 (after July 25, 1991, if elected), you In some cases, it is not immediately clear
will is often confused with an agreement not can depreciate it over 36 months if it meets whether property is a business asset or in-
to compete, and because goodwill is not de- ventory. In these cases, carefully examine all
all three of the following requirements:
preciable, you must establish from the facts the facts to see if it is depreciable property.
and circumstances whether you have pur- 1) It is readily available for purchase by the Containers. Containers are generally
chased goodwill or entered into an agree- general public, part of inventory and cannot be depreciated.
ment not to compete. However, certain durable containers used to
2) It is not subject to an exclusive license,
If you bought a business after August 10, ship products can be depreciated if they
and
1993 (after July 25, 1991, if elected), you have a life longer than 1 year, if they qualify
must amortize that part of its price that is for 3) It has not been substantially modified. as property used in your business, and if title
an agreement not to compete. If you can to them does not pass to the buyer. To deter-
amortize the cost of the agreement (as dis- Even if the software does not meet the mine if the above requirements apply and
cussed in chapter 13), you cannot depreci- above requirements, you can depreciate it whether your containers can be depreciated,
ate it. over 36 months if it was not acquired in con- you should consider:
nection with the acquisition of a substantial 1) Does your sales contract, sales invoice,
Designs and patterns. Designs and pat- portion of a business.
terns are kinds of intangible property that or acknowledgment of order indicate
If you acquire software after August 10, that you have retained title,
can be depreciated only if they have a deter-
1993 (after July 25, 1991, if elected), you
minable useful life and cannot be amortized 2) Does your invoice treat the containers
must amortize it over 15 years (rather than
(as discussed in chapter 13). as separate items, and
depreciate it) if it does not meet all three of
the requirements listed above and it was ac- 3) Do any of your records properly state
Franchise. A franchise is intangible property
quired in connection with the acquisition of a your basis in the containers.
that can be depreciated only if it has a deter-
substantial portion of a business. For more
minable useful life and cannot be amortized
(as discussed in chapter 13). information on amortization, see chapter 13. Manufacturing or processing businesses.
Software leased. If you lease software, If you must include depreciation as part of
Customer or subscription lists, location you can treat the rental payments in the the cost of goods sold, you cannot deduct
contracts, and insurance expirations. same manner that you treat any other rental this depreciation again as a separate busi-
Generally, you can depreciate these intangi- payments. ness expense on your return. See chapter 7
ble properties only if: for more information on cost of goods sold.
Goodwill. Goodwill can never be depreci-
1) Their value can be determined sepa- Rented property. Generally, a person who
rately from the value of any goodwill ated because its useful life cannot be
determined. uses depreciable property in a trade or busi-
that goes with the business, ness or holds it for producing income is enti-
However, if you acquired a business after
2) Their useful life can be determined with August 10, 1993 (after July 25, 1991, if tled to the depreciation deduction for the
reasonable accuracy, and elected), and part of the price includes good- property. This is usually the owner of the
3) They cannot be amortized (as dis- will, you may be able to amortize the cost of property. However, for rented property, this
cussed in chapter 13). the goodwill over 15 years. For more infor- is usually the lessor. An owner or lessor is
the person who generally bears the burden
mation, see chapter 13.
Computer software. Computer software in- of exhaustion of capital investment in the
cludes all programs designed to cause a property. This means the person who retains
Trademark and trade name. In general, the incidents of ownership for the property.
computer to perform a desired function. trademarks and trade names must be capi-
Computer software also includes any The incidents of ownership include:
talized. This means that the full amount can-
database or similar item that is in the public not be deducted in the current year. For 1) The legal title,
domain and is incidental to the operation of trademarks and trade names acquired 2) The legal obligation to pay for it,
qualifying software. before August 11, 1993 (before July 26,
Software developed before August 3) The responsibility to pay its mainte-
1991, if elected), you can neither depreciate
11, 1993. If you developed software pro- nance and operating expenses,
nor amortize these expenses. For trade-
grams before August 11, 1993 (before July 4) The duty to pay any taxes, and
marks and trade names acquired after Au-
26, 1991, if elected), you can choose to ei-
gust 10, 1993 (after July 25, 1991, if elected), 5) The risk of loss if the property is de-
ther treat the development costs as current
you may be able to amortize their costs over stroyed, condemned, or diminished in
expenses or capitalize the costs and depre-
ciate them using the straight line method 15 years. For more information, see chapter value through obsolescence or
over 5 years (or any shorter life you can 13. exhaustion.
clearly establish). You cannot change meth-
ods without the approval of the IRS. What Cannot Be Land. The cost of land can never be depre-
Software purchased before August ciated because land does not wear out or
11, 1993. If you purchased software before Depreciated become obsolete and it cannot be used up.
August 11, 1993 (before July 26, 1991, if To determine if you are entitled to deprecia- The cost of land generally includes the cost
elected), your recovery of costs depends on tion, you must know not only what you can of clearing, grading, planting, and landscap-
how you were billed. If the cost of the depreciate but what you cannot depreciate. ing because these expenses are all part of
Chapter 12 DEPRECIATION Page 49
the cost of land itself. However, you can de- Retired From Service What Costs Can and
preciate some land preparation costs if they Property is retired from service when it is
are so closely associated with a depreciable Cannot Be Deducted
permanently withdrawn from use in a trade
asset that it is possible to determine a life for You can claim the section 179 deduction
or business or in the production of income.
the preparation costs along with the life of only on qualifying property acquired for use
The period for depreciation ends when prop-
the asset with which they are associated. in your trade or business. You cannot claim
erty is retired from service.
the deduction on property you hold only for
You can retire property from service by the production of income.
Demolition of buildings. You cannot de- selling or exchanging it, abandoning it, or de-
duct costs (paid or incurred) to demolish any stroying it.
building. Nor can you deduct any loss from Acquired by Purchase
demolition. Instead, you must add these Only the cost of property you acquire for use
costs to the basis of the land on which the
Correct Depreciation Not in your business qualifies for the section 179
demolished building stood. Deducted deduction. However, the cost of property ac-
You cannot deduct unclaimed depreciation quired from a related person or group may
Equipment used to build capital improve- in any later tax year. However, you can claim not qualify. See Nonqualifying Property,
the depreciation on a timely filed amended later.
ments. You cannot deduct depreciation on
equipment you are using to build your own return for the year for which it should have
capital improvements. You must add depre- been claimed. You must file an amended re- Acquired by Trade
ciation on this equipment during the period turn within 3 years from the date you filed If you purchase an asset with cash and a
of construction to the basis of the improve- your original return, or within 2 years from the trade-in, part of the basis of the asset you re-
ments. See Uniform Capitalization Rules in time you paid your tax, whichever is later. A ceive is the basis of the trade-in. You cannot
chapter 5. return filed early is considered filed on the claim the section 179 deduction on this part
due date. of the basis of the asset. For example, if you
If you do not claim depreciation you are buy (for cash and a trade-in) a new truck to
Repairs and replacements. If a repair or
entitled to deduct, you must still reduce the use in your business, your cost for the sec-
replacement increases the value of your
basis of the property. Reduce the basis by tion 179 deduction does not include the ad-
property, makes it more useful, or lengthens
the amount of depreciation you were entitled justed basis of the truck you trade for the
its life, your repair or replacement cost must
to deduct. If you deduct more depreciation new vehicle. See Adjusted Basis in chapter
be capitalized and depreciated. If the repair
than you should, you must decrease your ba- 5.
or replacement does not increase the value
of your property, makes it more useful, or sis by any amount deducted from which you Example. In 1995, Just Sweets, a retail
lengthen its life, the cost of the repair or re- received a tax benefit. bakery, traded in two ovens with a total ad-
placement is deductible in the same way as justed basis of $680 for a new oven costing
$1,320. The bakery also traded a used ma-
any other business expense. See Additions
chine with an adjusted basis of $4,500 for a
or improvements to property, under Modified
Accelerated Cost Recovery System
Section 179 Deduction new machine costing $9,000. Both new
This discussion explains the section 179 de- items were placed in service in 1995. Just
(MACRS), later.
duction. It tells what costs can and cannot Sweets got an $800 trade-in on the old ov-
be deducted, how to elect the deduction, ens and paid $520 cash for the new oven.
Professional libraries. If you maintain a li- The bakery was given $4,800 trade-in and
brary for use in your profession, you can de- how to figure the deduction, and when to re-
paid $4,200 cash for the machine. The trans-
preciate it. Any technical books, journals, capture the deduction.
actions are nontaxable and no gain is recog-
and information services used in your busi- You can elect to treat all or part of the
nized on the trade-ins.
ness having a useful life of one year or less cost of certain qualifying property as an ex-
The part of the basis of the equipment
are deductible in the same way as any other pense rather than as a capital expenditure. If
carried over due to the transactions ($680
business expense. you make the election, you can deduct a lim-
for the oven and $4,500 for the machine) is
ited amount of the cost of qualifying property
not treated as business cost for the section
you buy for use in your trade or business only
When Depreciation 179 deduction. However, Just Sweets can
in the first year you place your property in
elect to deduct $4,720 ($520 and $4,200),
Begins and Ends service.
the part of the cost of the new property not
You begin to depreciate your property when determined by reference to the property
Placed in service. For the section 179 de- traded.
you place it in service for use in your trade or
duction, your property is considered placed
business or for the production of income.
in service when it is first ready and available
You stop depreciating property either when
for a specific use. Such use can be in a trade
Qualifying Property
you have fully recovered its cost or other ba- Property qualifying for the section 179 de-
or business, the production of income, a tax-
sis or when you retire it from service. (See duction is depreciable property and includes:
exempt activity, or a personal activity. Prop-
Retired From Service, later.)
erty placed in service in a use that does not 1) Tangible personal property,
qualify for the section 179 deduction cannot 2) Other tangible property (except most
Placed in Service later qualify in another tax year even if its use buildings and their structural compo-
For depreciation purposes, property is con- changes to business. nents) used as:
sidered placed in service when it is ready Example. In 1994, you bought a new car
a) An integral part of manufacturing, pro-
and available for a specific use, whether in a and placed it in service for personal pur-
duction, or extraction, or of furnishing
trade or business, the production of income, poses. In 1995, you began to use it for busi-
transportation, communications, elec-
a tax-exempt activity, or a personal activity. ness. The fact that you changed its use to tricity, gas, water, or sewage disposal
Even if the property is not actually being business use does not qualify the cost of services, or
used, it is in service when it is ready and your car for a section 179 deduction in 1995.
available for its specific use. However, you However, you can claim a depreciation de- b) A research facility in any of the activi-
can begin depreciating property only when it duction for the business use of the car in ties in (a), or
is ready and available for a specific use 1995. To figure this deduction, see Modified c) A facility in any of the activities in (a)
(placed in service) in a trade or business or Accelerated Cost Recovery System for the bulk storage of fungible
for the production of income. (MACRS), later. commodities,
Page 50 Chapter 12 DEPRECIATION
3) A single purpose agricultural (livestock) 3) Property acquired from certain groups is placed in service. You cannot make
or horticultural structure (defined later), or persons, and the election for the section 179 deduc-
and tion on an amended return filed after the
4) Certain property you lease to others (if
due date (including extensions).
4) Storage facilities (except buildings and you are a noncorporate lessor).
their structural components) used in dis-
tributing petroleum or any primary prod- For the kind of property you lease on which Once made, the election can be revoked
uct of petroleum. you can claim the section 179 deduction, only with the consent of the Internal Reve-
see Leased property, earlier. nue Service (IRS).
Single purpose structures. A single
purpose agricultural structure is any building Production of Income How To Figure
or enclosure specifically designed, built, and
used to:
Property is held only for the production of in- the Deduction
come if it is investment property, rental prop- The total business cost you can elect to de-
1) House, raise, and feed a particular type erty (if renting property is not your trade or duct under section 179 for a tax year cannot
of livestock (including poultry) and its business), or property that produces royal- be more than $17,500. This $17,500 maxi-
produce, and ties. Property you use in the active conduct mum dollar limit applies to each taxpayer,
2) House the equipment, including any of a trade or business is not held only for the not to each business. You do not have to
replacements, necessary to house, production of income. claim the full $17,500. You decide how much
raise, and feed this livestock. of the cost of property you want to deduct
Acquired From Certain Groups under section 179. Any cost you do not de-
A single purpose horticultural structure or Persons duct under section 179 can be depreciated.
is: Property does not qualify for the section 179 If you acquire and place in service more
deduction if: than one item of qualifying property during
1) A greenhouse specifically designed, the year, you can divide the deduction be-
built, and used for the commercial pro- 1) The property is acquired by one mem- tween the items in any way, as long as the
duction of plants, or ber of a controlled group from another total deduction is not more than the limits. If
2) A structure specifically designed, built, member of the same group, you have only one item of qualifying prop-
and used for the commercial production 2) The property for which the basis is de- erty, and it costs less than $17,500, such as
of mushrooms. termined in whole or in part by its ad- $3,200, your deduction is limited to the
justed basis in the hands of the person lesser of:
If a structure includes work space, that from whom you acquired it or is deter- 1) Your taxable income limit or
structure is not a single purpose agricultural mined under stepped-up basis rules for
or horticultural structure unless the work property acquired from a decedent (see 2) $3,200.
space is used only for: Publication 448), or
1) Stocking, caring for, or collecting live- You must figure your section 179 deduction
3) The property is acquired from a related
stock or plants or their produce, before figuring your depreciation deduction.
person.
Taxable income limit is discussed later under
2) Maintaining the enclosure or structure, Deduction Limits.
and For this purpose, a list of related persons is You must subtract the amount you elect
available in chapter 2 of Publication 946. to deduct from the business/investment
3) Maintaining or replacing the equipment
or stock enclosed or housed in the cost of the qualifying property. This result is
structure. Business and nonbusiness use. When you called your unadjusted basis and is used to
use property for both business and nonbusi- compute your depreciation deduction.
ness purposes, you can elect the section
179 deduction only if more than 50% of the
Leased property. Generally, taxpayers
property’s use in the tax year it is placed in
Deduction Limits
other than corporations cannot claim a sec- Your section 179 deduction cannot be more
service is for trade or business purposes.
tion 179 deduction based on property they than the business cost of the qualifying prop-
You must figure the part of the cost of the
lease to someone else. However, you can erty. In addition, in figuring your section 179
property that reflects only the business use
claim a section 179 deduction based on: deduction, you must apply the following
of the property. You do this by multiplying the
1) Property you lease to others that you cost of the property by the percentage of limits:
manufactured, or business use. This is your business cost and 1) Maximum dollar limit,
2) Property you lease to others if the term is used to figure your section 179 deduction.
2) Investment limit, and
of the lease is less than half of the
property’s class life and for the first 12 Electing the Deduction 3) Taxable income limit.
months the property is transferred to
You must make an election to take the sec-
the lessee, the total of the business de- Maximum dollar limit. The total cost you
tion 179 deduction. You can make this elec-
ductions that you are allowed on the can elect to deduct for a tax year cannot ex-
tion only in the first tax year the property is
property (except rent and reimbursed ceed $17,500. This $17,500 maximum ap-
placed in service. See Placed in service,
amounts) are more than 15% of the plies to each taxpayer and not to each busi-
earlier.
rental income from the property. ness operated by a taxpayer.
How to make the election. You make this While the maximum dollar amount that
election by taking the deduction on Form can be deducted is $17,500, there are cer-
Nonqualifying Property 4562 with: tain rules that can reduce this amount.
You cannot claim the section 179 deduction
1) Your original tax return filed for the tax
on: Joint returns. A husband and wife who file
year the property was placed in service
1) Property held only for the production of a joint return are treated as one taxpayer in
(whether or not you file it timely) or
income, determining any reduction to the $17,500
2) An amended return filed no later than maximum dollar limit, regardless of which
2) Real property including buildings and the due date (including extensions) for spouse acquired the property or placed it in
their structural components, your return for the tax year the property service.
Chapter 12 DEPRECIATION Page 51
Married individuals filing separate re- maximum deduction allowed ($17,500) by other disposition by the amount of disal-
turns. A husband and wife filing separate re- $7,000. If his taxable income limit is $10,500 lowed section 179 deduction.
turns for a tax year are treated as one tax- or more, he is entitled to a section 179 de- Neither the old nor the new owner can
payer for purposes of the $17,500 maximum duction for 1995 of $10,500. deduct any of the disallowed amount that is
dollar limit and the $200,000 investment limit added to the basis of the property.
that applies to the reduction of the maximum Taxable income limit. The total cost that
dollar limit. Unless they elect otherwise, can be deducted in each year is limited to the Passenger automobiles. For passenger
50% of the maximum dollar limit (after apply- taxable income from the active conduct of automobiles placed in service in 1995, your
ing the investment limit) will be allocated to any trade or business during the tax year. total section 179 deduction and depreciation
each. If the percentages elected by each Generally, you are considered to actively cannot be more than $3,060 for 1995. See
spouse do not total 100%, 50 % will be allo- conduct a trade or business if you meaning- Publication 917 for more information.
cated to each spouse. See Investment limit, fully participate in the management or opera-
later. tions of the trade or business. Two different taxable income limits. The
Example 1. Jack Elm is married. He and Taxable income for this purpose is fig- section 179 deduction is subject to a taxable
his wife file separate returns for 1995. Jack ured by totaling the net income (or loss) from income limit. You also may have to figure an-
bought and placed in service $200,000 of all trades and businesses you and your other deduction that has a limit based on tax-
qualified farm machinery in 1995. His wife spouse (if filing a joint return) actively con- able income. The limit for this other deduc-
had her own business and she placed in ser- ducted during the tax year. Items of income tion may have to be figured taking into
vice $5,000 of qualified business equipment. derived from a trade or business actively account the section 179 deduction. If so,
If Mr. and Mrs. Elm had filed a joint return for conducted by you include section 1231 complete the steps discussed next.
1995, their maximum dollar limit would have gains (or losses) as discussed in chapter 23 Step 1– Figure taxable income without
been $12,500. This is because their $17,500 of this publication, and interest from working either a section 179 deduction or the
maximum dollar limit would have been re- capital of your trade or business. Also in- other deduction.
duced by $5,000 (the excess over the clude in total taxable income any wages, sal-
aries, tips, or other compensation earned as Step 2– Figure a hypothetical section
$200,000 investment limit). They elect to al-
an employee. When figuring taxable income, 179 deduction using the taxable in-
locate the $12,500 as follows: $9,375 (75%)
do not take into account unreimbursed em- come figured in Step 1.
to Mr. Elm’s machinery and $3,125 (25%) to
Mrs. Elm’s equipment. If they did not make ployee business expenses you may have as Step 3– Subtract the hypothetical sec-
an election to allocate their costs, they an employee. tion 179 deduction figured in Step 2
would be limited to the $12,500 multiplied by In addition, taxable income is figured from the taxable income figured in
50% or $6,250 each on their separate without regard to: Step 1.
returns. 1) The section 179 expense deduction, Step 4– Figure a hypothetical amount for
Joint return after filing separate re- the other deduction using the amount
turns. If a husband and wife elect to file a 2) The self-employment tax deduction,
figured in Step 3 as taxable income.
joint return after the due date for filing the re- and
turn, the maximum dollar limit on the joint re- Step 5– Subtract the hypothetical other
3) Any net operating loss carryback or
turn is the lesser of: deduction figured in Step 4 from the
carryforward.
taxable income figured in Step 1.
1) The maximum dollar limit (after applying
the investment limit), or Example. Joyce Jones places in service Step 6– Now figure your actual section
in 1995 a machine that cost $8,000. The tax- 179 deduction using the taxable in-
2) The total cost of section 179 property come figured in Step 5.
able income from her business for 1995 (de-
they elected to expense on their sepa-
termined without a section 179 deduction for Step 7– Subtract your actual section 179
rate returns.
the cost of the machine and without the self- deduction figured in Step 6 from the
employment tax deduction) is $6,000. Her taxable income figured in Step 1.
Example 2. Assume Jack Elm and his section 179 deduction is limited to $6,000.
wife in Example 1 had filed separate returns. Step 8– Figure your actual other deduc-
The $2,000 cost that is not allowed as a cur-
On their separate tax returns, Jack elected tion using the taxable income figured
rent section 179 deduction because of the
to expense $4,000 of section 179 property in Step 7.
taxable income limit can be carried to 1996.
and his wife elected to expense $2,000. If Carryover of unallowable deduction.
they subsequently file a joint return after the The amount you carry over will be taken into Example. During the tax year, the XYZ
due date for that return, their maximum dol- account in determining the amount of your corporation purchased and placed in service
lar limit for section 179 is $6,000, the lesser section 179 deduction in the next year. In the qualifying section 179 property that cost
of $12,500 (the maximum dollar limit after tax year you place property in service, you $10,000. It elects to expense as much as
applying the investment limit) or $6,000 (the can select the properties for which costs will possible under section 179. The XYZ corpo-
total amount they elected to expense on be carried forward and you can allocate the ration also gave a charitable contribution of
their separate returns). portion of the costs to these properties pro- $1,000 during the tax year. A corporation’s
vided your decisions are shown in your deduction for charitable contributions can-
Investment limit. For each dollar of busi- books and records. not be more than 10% of its taxable income,
ness cost over $200,000 of section 179 See Carryover of disallowed deduction in figured after subtracting any section 179 de-
property placed in service in a tax year, the chapter 2 of Publication 946 for more infor- duction. The taxable income limit for the sec-
$17,500 maximum dollar limit is reduced (but mation on figuring the carryover; or to figure tion 179 deduction is figured after sub-
not below zero) by one dollar. If your busi- the carryover, use the Section 179 Work- tracting any allowable charitable
ness cost of section 179 property placed in sheet also provided in chapter 2 of Publica- contributions. XYZ’s taxable income figured
service during a tax year is $217,500 or tion 946. without taking into account either any sec-
more, you cannot take a section 179 deduc- Basis adjustment. Generally, upon a tion 179 deduction or any deduction for the
tion and you are not allowed to carryover the sale or other disposition of section 179 prop- charitable contributions is $12,000. XYZ
cost that is more than $217,500. erty, or a transfer of section 179 property in- figures its section 179 deduction and its de-
Example. In 1995, James Smith placed volving a transaction in which gain or loss is duction for charitable contributions as
in service machinery with a cost of $207,000. not recognized in whole or in part (including follows.
Because the cost of the machinery exceeds transfers at death), the adjusted basis of the Step 1– Taxable income figured without
$200,000 by $7,000, he must reduce the property is increased before the sale or either deduction is $12,000.
Page 52 Chapter 12 DEPRECIATION
Step 2– Using $12,000 as taxable in- year the election is made and all later tax MACRS consists of two systems for depreci-
come, a hypothetical section 179 de- years. ating property. The main system is called the
duction of $10,000 would be General Depreciation System (GDS) and
allowable. applies to most property. The second sys-
When To Recapture
Step 3– $12,000 (from Step 1) minus tem is called the Alternative Depreciation
$10,000 (from Step 2) equals $2,000.
the Deduction System (ADS). Unless ADS is specifically
If you claim a section 179 deduction for the required by law or you elect it, GDS is gener-
Step 4– Using $2,000 (from Step 3) as cost of qualifying property and, in a year after ally used to figure your depreciation
taxable income, a hypothetical chari- you place it in service, you do not use it deductions.
table contribution (limited to 10% of predominantly for business, you may have to
taxable income) of $200 is figured. recapture (include in income) part of the
Step 5– $12,000 (from Step 1) minus deduction. What Can Be
$200 (from Step 5) equals $11,800. You report any recapture of the section Depreciated
179 deduction on Form 4797.
Step 6– Using $11,800 (from Step 5) as
You figure the amount to include in in-
Under MACRS
taxable income, the actual section
come by subtracting the depreciation that MACRS applies to most tangible deprecia-
179 deduction is figured. Because the
taxable income is at least $10,000, would have been allowable on the section ble property placed in service after 1986.
XYZ can take a $10,000 section 179 179 amount for prior years and the year of Property for which you cannot use MACRS is
deduction. recapture from your section 179 deduction. discussed later in What Cannot Be Depreci-
If you elect the section 179 deduction, ated Under MACRS.
Step 7– $12,000 (from Step 1) minus
the amount deducted is treated as deprecia-
$10,000 (from Step 6) equals $2,000.
tion for purposes of the recapture rules. Any Use of real property changed. All real
Step 8– Using $2,000 (from Step 7) as gain you realize from a sale, exchange, or property acquired before 1987 that was
taxable income, the actual charitable other disposition of property may have to be changed from personal use to a business or
contribution (limited to 10% of taxa- treated as ordinary income up to the section income-producing use after 1986 must be
ble income) of $200 is figured. 179 and depreciation deductions claimed. depreciated under MACRS.
For more information on dispositions (includ-
Partnerships and partners. The section ing installment sales), see chapters 23 and
179 deduction limits apply to both the part- 24.
When To Use GDS
nership and to each partner. The partnership Most tangible depreciable property falls
Example. Paul Lamb, a calendar year
determines its section 179 deduction subject within the general rule of MACRS, also
taxpayer, bought and placed in service on
to the limits. It allocates the deduction called the General Depreciation System
August 1, 1993, an item of 3–year property
among its partners. (GDS). The major differences between GDS
costing $10,000. The property is not listed
Each partner adds the amount allocated property. He used the property only for busi- and ADS are the recovery period and
from the partnership as shown on Schedule ness in 1993 and 1994. He elected a section method of depreciation you use to figure the
K–1 to his or her other nonpartnership sec- 179 deduction of $5,000 for this property. deduction. Because GDS permits use of the
tion 179 costs and then applies the maxi- During 1995, he used the property 40% for declining balance method over a shorter re-
mum dollar limit to this total to determine his business and 60% for personal use. He covery period, the deduction is greater in the
or her section 179 deduction. To determine if figures his recapture amount as follows: earlier years.
a partner has passed the $200,000 invest- However, the law requires the use of
ment limit, the cost of section 179 property Section 179 Deduction Claimed ADS for certain property as discussed under
placed in service by the partnership is not at- (1992) $5,000.00 When To Use ADS, next.
tributed to any partner. The total amount of Allowable Depreciation Although your property may qualify for
each partner’s (partnership and nonpartner- (Instead of Section GDS, you can elect to use ADS. If you make
ship) section 179 deduction is subject to 179): this election, however, you can never revoke
both the taxable income limit and the maxi- it. How to make this election is discussed in
mum dollar limit. 1993 —
Election, under Depreciation Methods, later.
For more information about how the sec- $5,000 × 33.33%* $1,666.50
tion 179 deduction limits apply to partner- 1994 —
ships and partners, see Publication 946. $5,000 × 44.45%* 2,222.50 When To Use ADS
1995 — Under ADS, you determine your deduction
S corporations. The rules that apply to $5,000 × 14.81%* × by using the straight line method over a re-
partnerships and its partners also apply to an 40% (Business) 296.20 4,185.20 covery period that generally is longer than
S corporation and its shareholders. The lim- 1995 — the recovery period under GDS. This system
its apply to an S corporation and to each Recapture Amount $ 814.80 is required for:
shareholder. The corporation allocates the
deduction among the shareholders, who 1) Any tangible property used predomi-
*Rates from 200% table, later. nantly outside the United States during
then take the deduction subject to the limits.
For more information about how the sec- the year,
Paul must include $814.80 in income for
tion 179 deduction limits apply to an S corpo- 1995. This is $5,000 minus $4,185.20 2) Any tax-exempt use property,
ration and its shareholders, see Publication ($1,666.50 + $2,222.50 + $296.20).
946. 3) Any tax-exempt bond-financed
property,
Recordkeeping requirements. You must 4) Any imported property covered by an
keep records that show the specific identifi- Modified Accelerated executive order of the President of the
cation of each piece of section 179 property.
These records must show how the property Cost Recovery System United States, and
5) Any property used predominantly in a
was acquired, the person from whom it was
acquired, and when it was placed in service.
(MACRS) farming business and placed in service
You must stay with your selection of section The modified accelerated cost recovery sys- during any tax year in which you make
179 property for which you claim a deduction tem (MACRS) generally applies to all tangi- an election not to apply the uniform cap-
when computing taxable income for the tax ble property placed in service after 1986. italization rules to certain farming costs.
Chapter 12 DEPRECIATION Page 53
What Cannot 1) You or a party related to you owned or Basis
used the property in 1986, Basis is a measure of your investment in the
Be Depreciated property for tax purposes. When you depre-
2) The property was acquired from a per-
Under MACRS son who owned it in 1986 and, as part of ciate property, a certain percentage of your
You cannot use MACRS for certain property the transaction, the property user does basis in it is deducted each year.
because of special rules that exclude it from not change, For property that you buy, your original
MACRS. You can elect to exclude certain basis is usually its cost to you. For property
property from being depreciated under 3) You lease the property to a person (or a that you acquire in some other way, such as
MACRS. person related to this person) who by inheriting it, receiving it as a gift, building it
Property that you cannot depreciate us- owned or used the property in 1986, or yourself, or getting it in a tax-free exchange,
ing MACRS includes: 4) The property was acquired in a transac- you must figure your original basis in some
1) Intangible property, tion in which the property user did not other way.
change and the property was not Events will often change the basis of a
2) Any motion picture film or video tape,
MACRS property in the hands of the piece of property. This changed basis is
3) Any sound recording, person from whom it was so acquired called the adjusted basis. Some events,
4) Certain real and personal property because of 2) or 3). such as improvements, increase basis.
placed in service before 1987, and Some, such as casualty losses and the sec-
Real property. For real property placed tion 179 deduction, decrease basis. If basis
5) Property you elect to exclude from
in service after 1986 (after July 31, 1986, if is adjusted, the depreciation deduction may
MACRS that is properly depreciated
MACRS was elected), you cannot use also have to be changed, depending on the
under a method of depreciation that is
MACRS if: reason for the adjustment and on the
not based on a term of years.
method of depreciation you are using.
1) You or a party related to you owned the Chapter 5 explains how to figure basis for
Election to exclude certain property. If property in 1986, property acquired in different ways and how
you properly depreciate any of your property
to allocate basis among assets. It also ex-
under a method of depreciation that is not 2) You lease the property back to the per-
plains what items increase or decrease
based on a term of years, such as the unit-of- son (or a person related to this person)
basis.
production method, you can elect to exclude who owned the property in 1986, or
that property from MACRS. To figure a de- 3) You acquired the property in a transac- Basis of property changed from personal
preciation deduction under the unit-of-pro- tion in which some of your gain or loss use. If you held property for personal use
duction method, you divide the cost or other was not recognized. MACRS applies and later change it to business use or use in
basis (less salvage) by the estimated num- only to the part of your basis in the ac- the production of income, your basis is the
ber of units to be produced during the life of quired property that represents cash lesser of:
the asset. Apply the resulting amount to the paid or unlike property given up. It does
units produced in a year to arrive at your de- 1) The fair market value (FMV) on the date
not apply to the substituted portion of
preciation for that year. you change it from personal use, or
the basis.
You make this election by reporting your 2) Your original cost or other basis ad-
depreciation for the property on line 18, of justed as follows:
Part III on Form 4562, and attaching a state- Note: This rule does not apply to non-
ment as described in the Instructions for residential real property or residential rental a) Increased by the cost of any perma-
Form 4562. You make the election by the tax property. nent improvements or additions and
return due date (including extensions) for the other costs that must be added to ba-
Related parties. For these rules, a party sis, and
year the property is placed in service. related to you includes members of your im-
mediate family (including your spouse, an- b) Decreased by any tax deductions you
Use of standard mileage rate. If you use cestors, and lineal descendants). claimed for casualty losses and other
the standard mileage rate for an automobile Special rule. The excluded property charges to basis claimed on earlier
you buy and use for business after 1980, you rules do not apply to any property if the al- years’ income tax returns.
are considered to have elected to exclude lowable deduction for the property for the
the automobile from MACRS and ACRS. first tax year in which the property is placed
See chapter 15 of this publication for a dis- in service using ACRS is greater than the de- Property Classes and
cussion of the standard mileage rate. duction under MACRS using the half-year Recovery Periods
convention. Each item of property depreciated under
Property placed in service before 1987. For more information on related parties
There are special rules that may prevent you GDS is assigned to a property class. The
and other special rules, see chapter 3 of property class of an item of property estab-
from using MACRS for property placed in Publication 946.
service by you or anyone (for any purpose) lishes the number of years over which the
before 1987 (before August 1, 1986, if basis of the property is recovered. This pe-
MACRS was elected). These excluded prop- How To Figure the riod of time is called a recovery period.
erty rules apply to both personal and real Deduction GDS. Under GDS, most types of tangible
property. However, the rules for personal
property are more restrictive. Using Percentage Tables property fall into one of the following
To figure MACRS deduction, you generally classes:
Note: For these rules, neither real nor must first determine the following informa- 3–year property. This class includes
personal property is treated as owned tion about the property you intend to tractor units for use over the road,
before it is placed in service. If you owned depreciate. any race horse over 2 years old when
property in 1986 but did not place it in ser- 1) Its basis, placed in service, and any other
vice until 1987, it is not treated as owned in horse over 12 years old when placed
1986. 2) Its property class and recovery period, in service.
Personal property. You cannot use 3) Its date placed in service, 5–year property. This class includes au-
MACRS for personal property (section 1245 tomobiles, buses, trucks, computers
4) Which convention to use, and
property) that you acquired after 1986 (after and peripheral equipment, office ma-
July 31, 1986, if MACRS was elected) if: 5) Which depreciation method to use. chinery (typewriters, calculators,
Page 54 Chapter 12 DEPRECIATION
copiers, etc.), and any property used Additions or improvements to property. be required to use the mid-quarter conven-
in research and experimentation. Additions or improvements you make to any tion. For residential rental and nonresidential
7–year property. This class includes of- property, including leased property, are real property, you use the mid-month con-
fice furniture and fixtures (desks, files, treated as separate property items for depre- vention in all situations.
etc.). ciation purposes. The recovery period for an
Any property that does not have a addition or improvement to property begins Half-year convention. Under the half-year
class life, and that has not been des- on the later of the date the addition or im- convention, treat all property placed in ser-
ignated by law as being in any other provement is placed in service or the date vice, or disposed of, during a tax year as
class and, if placed in service before the property to which the addition or im- placed in service, or disposed of, at the mid-
1989, any single purpose agricultural provement is made is placed in service. The point of that tax year.
or horticultural structure is also 7-year recovery period and class of the addition or
property. improvement is the one that would apply to Mid-quarter convention. If during any tax
the underlying property if it were placed in year the total depreciable bases of all
10–year property. This class includes
service at the same time as the addition or MACRS property placed in service during
vessels, barges, tugs, and similar
improvement. the last 3 months of that tax year exceeds
water transportation equipment, and,
40% of the total depreciable bases of all
if placed in service after 1988, any
Office in the home. If you begin to use part MACRS property placed in service during
single purpose agricultural or horticul-
of your home as an office after 1986, that that tax year, you must use the mid-quarter
tural structure, and any tree or vine
part of your home is depreciated as nonresi- convention instead of the half-year conven-
bearing fruit or nuts.
dential real property over 39 years (31.5 tion. In determining the total bases of the
15–year property. This class includes years for property you placed in service properties, do not include the basis of:
certain depreciable improvements before May 13, 1993) under GDS. See Pub- Residential rental property,
made directly to land or added to it, lication 587 for a discussion of the tests that
such as shrubbery, fences, roads, Nonresidential real property, or
must be met to claim expenses, including
and bridges. depreciation, for the business use of your Property placed in service and disposed
20–year property. This class includes home. of in the same tax year.
farm buildings (other than agricultural
or horticultural structures) and any Personal residences changed to rental To determine whether you must use the
municipal sewers. use. If you begin to rent a residence after mid-quarter convention, the depreciable ba-
Nonresidential real property. This 1986 that was your personal residence sis of property is your basis multiplied by the
class includes any section 1250 real before 1987, you depreciate it as residential percentage of business/investment use and
property that is not: rental property over 27.5 years under GDS. then reduced by:
a) Residential rental property, or 1) The amount of amortization taken on
Placed-in-Service Date the property,
b) Property with a class life of less than
27.5 years. As discussed in Placed in Service in When 2) Any section 179 deduction claimed on
The recovery period for nonresidential real Depreciation Begins and Ends, earlier, de- the property, and
property is: preciation begins when your property is 3) Any deduction claimed for clean-fuel ve-
placed in service in a trade or business or for hicles or for clean-fuel vehicle refueling
39 years for property you placed in the production of income. For example, if
service after May 12, 1993, or property.
property is placed in service for personal
31.5 years for property you placed in use, depreciation is not allowable. If the Under the mid-quarter convention, you
service before May 13, 1993. property use changes to a business or in- treat all property placed in service, or dis-
However, property you placed in service come-producing activity, depreciation be- posed of, during any quarter of a tax year as
before January 1, 1994, will not be subject to gins at the time of the change in use. placed in service, or disposed of, at the mid-
the longer recovery period if you or a ‘‘quali- Example 1. On November 22, 1994, point of the quarter.
fied person’’ entered into a binding written Donald Steep bought a machine for his busi- To figure your MACRS deduction for
contract to purchase or construct the prop- ness. It was delivered on December 7, 1994. property subject to the mid-quarter conven-
erty before May 13, 1993, or you (or a quali-
However, it was not installed and operational tion, first figure your depreciation for the full
fied person) began construction of the prop-
until January 3, 1995. Because it was not op- tax year. Then multiply this amount by the
erty before May 13, 1993. A qualified
erational until 1995, it is considered placed in following percentages for the quarter of the
person is anyone who transfers a contract
service in 1995. If the machine had been tax year the property is placed in service:
or property to you so long as the property
ready for use when it was delivered in 1994,
was not put in service by the transferor. See Quarter of tax year Percentage
it would be considered placed in service in
Publication 946 for the 39–year nonresiden- First 87.5%
1994 even if it was not actually used until
tial real property table. Second 62.5%
1995.
Residential rental property. This class Third 37.5%
Example 2. On April 6, Sue Thorn
includes any real property that is a Fourth 12.5%
bought a house to use as residential rental
rental building or structure (including
property. She made several repairs and had For more information including percent-
mobile homes) if 80% or more of the
it ready for rent on July 5. At that time, she age tables based on the mid-quarter con-
property’s gross rental income for the
began to advertise it for rent in the local vention, see Publication 946.
tax year is rental income from dwell-
newspaper. The house is considered placed
ing units. If you occupy any part of the
in service in July when it was ready and avail- Mid-month convention. Under the mid-
building or structure, the gross rental
able for rent. She can begin to depreciate it month convention, you treat all property
income includes the fair rental value
in July. placed in service, or disposed of, during any
of the part you occupy. The recovery
period for this property is 27.5 years. month as placed in service, or disposed of,
Conventions at the midpoint of that month.
The class lives and recovery periods for Generally, you use the half-year convention Example. You buy a building for
most assets are listed in the Table of Class to figure the deduction for property other $100,000 that is nonresidential real property.
Lives and Recovery Periods in Appendix B of than residential rental and nonresidential You place it in service in your business on
Publication 946. real property. Under a special rule, you may January 7, 1995. You use the calendar year
Chapter 12 DEPRECIATION Page 55
as your tax year. You do not use the tables to class applies to all property in that class Depreciation Methods Chart
compute your depreciation deductions. You placed in service in the tax year of the
figure your MACRS depreciation for the election. Method-
building by dividing 1 by 39 years to get the The election is made by entering ‘‘150 Property Class Recovery Period
straight line rate for a full year of 2.564%. DB’’ in column (f) of Part II on Form 4562. 3, 5, 7, 10–Year 200% DB-GDS
The depreciation for a full year is $2,564 (Nonfarm) 150% DB-ADS*
(2.564% × $100,000). Under the mid-month ADS method. If you choose, you can use SL-GDS*
convention, January, the month the property the ADS method. Under this method, depre- SL-ADS*
is placed in service, is treated as half a ciation is figured using the straight line 3, 5, 7, 10–Year (Farm) 150% DB-GDS
month. You would get 11.5 months of depre- method but over ADS recovery periods. 150% DB-ADS*
ciation for 1995. Expressed as a percentage, ● For residential rental and nonresidential SL-GDS*
11.5 months is 95.8% (11.5 ÷ 12). Your real property, the straight line method is SL-ADS*
1995 depreciation for the building is $2,456 applied to a 40–year recovery period with
(95.8% × $2,564). the mid-month convention.
15, 20–Year (Farm or 150% DB-GDS
Nonfarm)
● For automobiles and light general purpose SL-GDS*
Depreciation Methods trucks, the straight line method is applied SL-ADS*
Under MACRS, there are five ways to depre- over a 5–year period with either the half-
ciate your property. Nonresidential Real SL-GDS
year or mid-quarter convention.
Property SL-ADS*
200% declining balance method. You can
● For single purpose agricultural and horti- Residential Rental
use the (200%) declining balance method cultural structures, it is applied over a 15– Property
for nonfarm property in the 3–, 5–, 7–, or 10– year period with either the half-year or Trees or Vines Bearing
year class over a GDS recovery period and mid-quarter convention. Fruit or Nuts
apply a half-year or mid-quarter convention ● For any tree or vine bearing fruit or nuts, it Tax-Exempt Use SL-ADS
(discussed earlier). is applied over a 20–year period with ei- Property
ther the half-year or mid-quarter Tax-Exempt Bond-
150% declining balance method. You use convention. Financed Property
the 150% declining balance method for all Imported Property
property in farming businesses (except real The ADS recovery periods for many as- Foreign Use Property
property) and for all other property in the 15- sets can be found in the Table of Class Lives (Used Outside U.S.)
and 20-year property classes. and Recovery Periods in Appendix B of Pub-
*Elective Method
For these classes of property, you lication 946.
change to the straight line method for the Election of ADS. You make the election
first tax year for which that method, when ap- to use the ADS method by completing line MACRS Deductions
plied to the adjusted basis at the beginning 16 of Part II of Form 4562. Make the election
of such year, will yield a larger deduction. by the tax return due date (including exten- You may determine your MACRS deprecia-
You always use the straight line method for sions) for the year the property is placed in tion deduction in one of two ways. You can
residential rental and nonresidential real service. use the percentage tables discussed next, or
property. The election of the ADS method for one you can actually compute the deduction us-
item in a property class generally applies to ing the applicable depreciation method and
all property in that class placed in service convention over the recovery period.
Straight line election. Instead of using the
declining balance method over the GDS re- during the tax year of the election. However,
covery period, you can elect to use the you can make the election on a property-by- MACRS Percentage tables. The percent-
straight line method over the GDS recovery property basis for residential rental and non- age tables are based on the depreciation
period. residential real property. method, recovery period, and convention.
The election to use the straight line Once made, the election to use the ADS The percentages in the tables are applied to
method for one item in a property class ap- method cannot be changed. the unadjusted basis of the property each
plies to all property in that class placed in year of the recovery period. Unadjusted ba-
service in the year of the election. Once Depreciation Methods Chart sis is the same amount you would use to
made,the election to use the straight line compute a gain on a sale but it is figured
To help you determine the proper method for
method cannot be changed. without taking into account any depreciation
a specific property class, use the following
The election is made by entering ‘‘S/L’’ taken in earlier years. However, you do re-
chart. The declining balance method is
in column (f) of Part II of Form 4562. The duce your basis by:
shown as DB and the straight line method as
election must be made by the tax return due SL. 1) The amount of amortization taken on
date (including extensions) for the year the the property,
property for which you make the election is
2) Any section 179 deduction claimed, and
placed in service. However, this election can
be made each year for each property class. 3) Any deduction claimed for clean-fuel ve-
hicles and clean-fuel vehicle refueling
150% election. Instead of using the 200% property.
declining balance method over the GDS re-
covery period, you can elect to use the Also, if the business property is a vehicle,
150% declining balance method over the you must reduce the basis by any qualified
ADS recovery period for the property. If the electric vehicle credit.
property does not have an ADS recovery pe- However, you cannot continue to use the
riod assigned to it, the recovery period is 12 tables if there are any adjustments to the ba-
years. A half-year or mid-quarter convention sis of your property for reasons other than:
is used and there is a change to the straight
1) Depreciation allowed or allowable, or
line method when that method will give a
larger deduction. 2) An addition or improvement to that
The election to use the 150% declining property depreciated as a separate item
balance method for one item in a property of property.
Page 56 Chapter 12 DEPRECIATION
For example, if the basis of the property apply the half-year convention to figure your How To Group Property in
is reduced as a result of a casualty to the depreciation for the first year. In the second General Asset Accounts
property, you cannot continue to use the year, first reduce your basis for the amount
Each general asset account must include
tables. of depreciation allowable for the first year.
only property that:
For the year of adjustment and the re- Then multiply this adjusted basis by the
mainder of the recovery period, you must same rate used in the first year. 1) Has the same asset class,
compute your depreciation based on the ad- 2) Has the same recovery period,
justed basis of the property at the end of the Declining balance rates. The following ta-
tax year of adjustment and the remaining re- ble shows the applicable declining balance 3) Has the same depreciation method,
covery period. For more information, see rate for each class of property and the first 4) Has the same convention, and
How To Figure the Deduction Without Using year for which the straight line method will
the Tables in chapter 3 of Publication 946. 5) You placed in service in the same tax
give an equal or greater deduction. For 3–,
In addition, you cannot use the tables if year.
5–, 7–, and 10–year nonfarm property, the
you have a short tax year. If this occurs, see rate is based on the 200% declining balance
MACRS Deduction in Short Tax Year in The following rules also apply when you
method. For farm property and 15– and 20–
chapter 3 of Publication 946. establish a general asset account:
year property, it is based on the 150% de-
clining balance method. 1) Property without an asset class, but with
200% table. The following table has the the same depreciation method, recov-
percentages for 3–, 5–, and 7–year nonfarm Class Declining Balance Rate Year ery period, and convention, that you
property. The percentages are based on the 3 66.67% 3rd place in service in the same tax year,
200% declining balance method over GDS 5 40% 4th can be grouped into the same general
recovery periods and apply a half-year con- 7 28.57% 5th asset account;
vention with a change to the straight line 10 20% 7th 2) Property subject to the mid-quarter con-
method. See Appendix A in Publication 946
15 10% 7th vention can only be grouped into a gen-
for complete MACRS tables, including tables
20 7.5% 9th eral asset account with property that is
for the mid-quarter convention.
placed in service in the same quarter of
Year 3–Year 5–Year 7–Year the tax year;
Straight line method. When using the
1 33.33% 20% 14.29% straight line method, you must determine a 3) Property subject to the mid-month con-
2 44.45% 32% 24.49% new depreciation rate for each tax year in vention can only be grouped into a gen-
3 14.81% 19.2% 17.49% the recovery period. For any tax year, the eral asset account with property that is
4 7.41% 11.52% 12.49% placed in service in the same month of
straight line rate is determined by dividing
5 11.52% 8.93% the taxable year; and
the number 1 by the years remaining in the
6 5.76% 8.92%
recovery period at the beginning of the tax 4) Passenger automobiles subject to the
7 8.93%
year. The rate is applied to the unrecovered limits on passenger automobile depre-
8 4.46%
basis of the property. If the remaining recov- ciation must be grouped into a separate
ery period at the beginning of the tax year is general asset account.
Example. You buy an item of 7–year
less than 1 year, the straight line rate for that
property for $10,000 and place it in service
tax year is 100%.
on August 10, 1994. You do not elect a sec-
tion 179 deduction. The unadjusted basis of For example, the straight line method ap- Dispositions and Conversions
the property is $10,000. You use the per- plied to property with a 5–year recovery pe-
When you transfer ownership of property in a
centage tables to figure your deduction. riod results in a straight line rate of 20% (1 ÷
general asset account or you permanently
You multiply $10,000 by 14.29% to get 5) for a full tax year. After applying the half-
withdraw it from use in your trade or busi-
your depreciation for 1994 of $1,429 for this year convention, the first year rate is 10%. At
ness or from the production of income, it is
item of 7–year property. For 1995, you multi- the beginning of the second year, the re-
considered disposed of. A disposition also
ply $10,000 by 24.49% to get your deprecia- maining recovery period is 4.5 years as a re-
occurs when you transfer property to a sup-
tion deduction of $2,449. sult of the half-year convention. The straight
plies, scrap, or similar account. A disposition
line rate for the second year is 22.22% (1 ÷
includes the sale, exchange, retirement,
4.5). This second year rate is applied to the
How to figure the deduction without us- physical abandonment, or destruction of
cost or other basis of the property reduced
ing the tables. Instead of using the percent- property; a disposition does not include,
by the depreciation taken in the first year.
age tables to figure depreciation, you can ac- the retirement of a structural component of
tually compute your depreciation deduction real property.
each year. You must apply the appropriate General Asset Accounts The unadjusted depreciable basis and
convention for the first year. You can choose to put certain depreciable the depreciation reserve of the general as-
property subject to MACRS in one or more set account are not affected by your disposi-
Note. Figuring MACRS deductions with- general asset accounts. After you have set tion of property from the general asset
out using the tables will generally result in a up a general asset account, you generally account.
slightly different amount than using the figure the depreciation for each general as- Property you change to personal use
tables. set account by using the depreciation must be removed from the general asset
method, recovery period, and convention account.
Declining balance method. To figure your that applies to the property in the account. Unadjusted depreciable basis. The un-
MACRS deduction, first determine your de- For each general asset account, record the adjusted depreciable basis of an item of
clining balance rate. Do this by dividing the depreciation allowance in a separate depre- property in a general asset account is the
specified declining balance percentage ciation reserve account. same amount you would use to figure gain
(150% or 200%) by the recovery period. For on the sale of the property, but is figured
example, for 3–year nonfarm property, you Property you cannot include. You cannot without taking into account any depreciation
divide 2.00 by 3 to get .6667 or 66.67%. For include property in a general asset account if taken in earlier years.
15–year property, you divide 1.50 by 15 to you use it in both a trade or business (or for The unadjusted depreciable basis of a
get .10 or 10%. the production of income) and in a personal general asset account is the total of the un-
You multiply the unadjusted basis of the activity in the tax year in which you first adjusted depreciable bases of all of the
property by the declining balance rate and place it in service. property in the account.
Chapter 12 DEPRECIATION Page 57
For more information on general asset of a dwelling unit, if, and only if, that por- Alternative minimum tax. If you use accel-
accounts, see chapter 3 of Publication 946. tion is used both regularly and exclu- erated depreciation, you may need to figure
sively for business as discussed in Pub- alternative minimum tax. For more informa-
lication 587, tion about the alternative minimum tax rules
applicable to individuals, see Form 6251, Al-
Listed Property 5) Any cellular telephone (or similar tele- ternative Minimum Tax–Individuals, and for
There are limits on the depreciation deduc- communication equipment) placed in the rules applicable to corporations, see
tions you can claim on listed property. If your service or leased in a tax year beginning Chapter 34 in this publication.
listed property is not used more than 50% in after 1989.
business use during any tax year, the section
179 deduction is not allowable and you must
depreciate the property using the ADS
method. ADS uses the straight line method
What Records Form 4562
and is discussed earlier under When To Use Must Be Kept
ADS. Limitations are also imposed on les- Form 4562 is used by most taxpayers re-
You cannot take any depreciation or section porting depreciation, amortization, or the
sees that are similar to those imposed on
179 deduction for the use of listed property section 179 deduction.
owners. See chapter 4 of Publication 946.
(including passenger automobiles) unless File Form 4562 only if:
In addition to the rules for all listed prop-
you can prove business/investment use by
erty, there is a special dollar limit on the de-
preciation and section 179 deduction you adequate records or sufficient evidence to 1) You are claiming depreciation on prop-
can claim each year for passenger automo- support your own statements. erty placed in service this year,
biles. For passenger automobiles placed in
service in 1995, your total section 179 de- Adequate Records 2) You are claiming a section 179
duction and depreciation cannot exceed deduction,
$3,060. For the second year, it cannot ex- To meet the adequate records requirement,
ceed $4,900. It cannot exceed $2,950 in the you must maintain an account book, diary, 3) You are beginning to claim amortization
third year and $1,775 each later year. For log, statement of expense, trip sheet, or simi- this tax year,
more information, see Publication 917. lar record or other documentary evidence
that, together with the receipt, is sufficient to 4) You are claiming depreciation on any
Listed property defined. Listed property is establish each element of an expenditure or listed property,
any of the following: use. It is not necessary to record information
in an account book, diary, or similar record if
1) Any passenger automobile, 5) You are claiming a deduction for any ve-
the information is already shown on the re-
2) Any other transportation vehicle, hicle reported on a form other than
ceipt. However, your records should back up Schedule C or Schedule C–EZ, or
3) Any property of a type generally used your receipts in an orderly manner.
for entertainment, recreation, or For listed property, you must keep
6) You are filing a corporate tax return
amusement, records for as long as any excess deprecia-
(other than Form 1120S).
4) Any computer and related peripheral tion can be recaptured (included in income).
equipment unless it is used only at a For property placed in service after 1986,
regular business establishment and recapture can occur in any tax year of the If you do not have to file Form 4562, claim
owned or leased by the person operat- ADS recovery period. depreciation on the appropriate line of your
ing the establishment. A regular busi- For more information, see Publication tax return. A sample Form 4562 is illustrated
ness establishment includes a portion 946 in Part 8, Filled-In Forms in this publication.
Page 58 Chapter 12 DEPRECIATION
3) Workforce in place including its compo-
Amortization sition, and terms and conditions (con-
13. Amortization lets you recover certain capital
tractual or otherwise) of its employment,
expenses in a way that is like straight line de- 4) Business books and records, operating
Amortization preciation. Only certain specified expenses systems, and any other information
base, including lists, or other informa-
can be amortized for federal income tax pur-
and Depletion poses. The different types of expenses that tion with respect to current or prospec-
tive customers,
can be amortized are discussed in this chap-
ter. For a more detailed discussion of amorti- 5) A patent, copyright, formula, process,
zation, see chapter 12 of Publication 535. design, pattern, know-how, format, or
If you want to amortize your expenses, similar item,
Important Reminder you usually must make an election to do so. 6) A customer-based intangible,
The election is made by filing Form 4562 and
Amortization of certain intangibles. You attaching a required statement to your in- 7) A supplier-based intangible,
may have to amortize, over 15 years, certain come tax return. Unless otherwise indicated, 8) Any other item similar to those in items
intangibles that you hold in connection with a you enter your deduction in Part VI, Amorti- 3 through 7.
trade or business or an activity for the pro- zation, of Form 4562.
duction of income. 9) A license, permit, or other right granted
For more information, see Amortization by a governmental unit or agency (in-
of Certain Intangibles, later. cluding renewals),
Amortization of Certain 10) A covenant not to compete entered into
in connection with an acquisition of an
Intangibles interest in a trade or business, and
Introduction You must amortize over 15 years, the capi- 11) A franchise, trademark, or trade name
You may be able to deduct each year, as talized costs of certain intangibles that you (including renewals).
amortization, a part of certain capital ex- acquire after August 10, 1993. These in-
penses. Amortization generally allows a tangibles are called ‘‘amortizable section You cannot amortize any of the intangibles
write off of your costs that are not ordinarily 197 intangibles’’ and are defined later. They listed in items (1) through (8) that you cre-
deductible. See chapter 12 for information must be held in connection with your trade or ated, unless you created it in connection with
on depreciation. business or in an activity engaged in for the the acquisition of assets constituting a trade
If you have an exhaustible natural re- production of income. The amount of your or business or substantial portion of a trade
source or timber, you are allowed a depletion deduction is the adjusted basis (for purposes or business.
deduction. Depletion is discussed later in of determining gain) of the intangible amor- For more information on these section
this chapter. tized over a 15-year period beginning with 197 intangibles, see chapter 12 in Publica-
the month acquired. No other depreciation tion 535.
or amortization deduction is allowed for sec-
Topics tion 197 intangibles.
This chapter discusses: Workforce in place. This includes the com-
position of a workforce (for example, its ex-
● Amortizing qualified expenses Effective date elections. While this amorti- perience, education, or training), the terms
zation provision generally applies only to and conditions of employment whether con-
● Mineral property
property acquired after August 10, 1993, tractual or otherwise, and any other value
● Oil and gas wells under two elections, you may choose to placed on employees or any of their attrib-
have it apply differently. utes. Therefore, the part of a purchase price
● Natural and geothermal deposits
First, you can choose to apply this amor- of a trade or business attributable to the ex-
● Timber tization provision to section 197 intangibles istence of a highly-skilled workforce, or the
acquired after July 25, 1991, and before Au- cost of acquiring an existing employment
gust 11, 1993. Once made, the election ap-
Useful Items contract or relationship with employees or
plies to all section 197 intangibles acquired consultants as part of the acquisition of a
You may want to see:
during that period and it can only be revoked trade or business are examples of workforce
with the consent of the IRS. in place.
Publication Second, you can choose not to apply
□ 533 Self-Employment Tax this amortization provision to section 197 in- Customer-based intangible. A customer-
tangibles acquired after August 10, 1993, if based intangible is the composition of mar-
□ 535 Business Expenses they were acquired under a binding written ket, market share, and any other value re-
□ 544 Sales and Other Dispositions of contract in effect on that date and at all times sulting from the future provision of goods or
Assets thereafter until the property was acquired. services because of relationships with cus-
Once made, the choice applies to all prop- tomers in the ordinary course of business.
□ 550 Investment Income and erty acquired under that contract, and the
Expenses That part of the purchase price of a trade or
choice can only be revoked with the consent business that is based on the existence of a
of the IRS. This election may not be made if customer base, circulation base, undevel-
Form (and Instructions) you have chosen to apply the new amortiza- oped market or market growth, insurance in
□ T Forest Industries Schedules tion provision to all section 197 intangibles force, mortgage servicing contracts, invest-
acquired after July 25, 1991, as discussed in ment management contracts, or other rela-
□ Sch E (Form 1040) Supplemental the preceding paragraph. tionships with customers that involve the fu-
Income and Loss
ture provision of goods or services must be
□ Sch SE (Form 1040) Self- Section 197 Intangibles amortized over 15 years.
Employment Tax The following assets are section 197
intangibles: Supplier-based intangible. A supplier-
□ 4562 Depreciation and Amortization
based intangible is the value resulting from
□ 6251 Alternative Minimum Tax— 1) Goodwill, the future acquisition of goods or services
Individuals 2) Going concern value, because of relationships in the ordinary
Chapter 13 AMORTIZATION AND DEPLETION Page 59
course of business with suppliers of goods If depreciation is allowed for any com- you acquired the intangible in a transaction
or services to be used or sold by the busi- puter software that is not a section 197 in- one of the principal purposes of which is to:
ness. That part of the purchase price of a tangible, use the straight line method with a
1) Avoid the requirement that the intangi-
trade or business that is based on the exis- useful life of 36 months.
ble be acquired after August 10, 1993,
tence of a favorable relationship with distrib- For more information on depreciation of
or
utors (such as favorable shelf or display computer software, see Publication 946.
space at a retail outlet), the existence of a 2) Avoid any of the anti-churning rules.
favorable credit rating, or the existence of Additional costs associated with nonsec-
favorable supply contracts must be amor- tion 197 intangibles. Additional costs that For more information on amortizable sec-
tized over 15 years. are taken into account in determining the ba- tion 197 intangibles, see chapter 12 in Publi-
sis of property that is not a section 197 intan- cation 535.
Other intangibles. The following assets are gible are not themselves section 197 in-
not section 197 intangibles: tangibles. For example, none of the costs of
acquiring real property held for the produc-
Going Into Business
1) Any interest in a corporation, partner- When you go into business, all the costs you
tion of rental income (including goodwill, go-
ship, trust or estate, or under an existing have to get your business started are treated
ing concern value, etc.) is an amortizable
futures contract, foreign currency con- as capital expenses and are part of your ba-
section 197 intangible. These costs are in-
tract, notional principal contract, or simi- sis in the business. Any costs that are for
stead, added to the basis of the real
lar financial contract, particular assets can generally be recovered
property.
2) Any interest in land, through depreciation deductions. Other
costs generally cannot be recovered until
3) Most computer software (see Computer Dispositions you sell or otherwise go out of business. See
software, later), A section 197 intangible is treated as depre- Going Into Business in chapter 4 for a dis-
4) Any of the following not acquired in con- ciable property used in your trade or busi- cussion of how to treat these costs if you do
nection with the acquisition of a trade or ness. If you dispose of a section 197 intangi- not go into business.
business or a substantial part of a trade ble that you held for more than 1 year, the However, you can elect to amortize cer-
or business: property qualifies as section 1231 property. tain costs that you have in setting up your
Any gain on the disposition is treated as ordi- business. These costs are deducted in equal
a) An interest in a film, sound recording, nary income to the extent of the allowable
videotape, book, or similar property, amounts over a period of 60 months or
amortization. The gain or loss on the sale of more. To be amortizable in this way, costs
b) A right to receive tangible property or property held for 1 year or less is reported as
must qualify in one of the following three
services under a contract or granted an ordinary gain or loss. See chapter 2 in
areas:
by a governmental agency, Publication 544, Sales and Other Disposi-
tions of Assets, for more information. 1) Business start-up costs,
c) An interest in a patent or copyright,
If you acquire more than one section 197 2) Organizational costs for a corporation,
d) A right under a contract (or a right intangible in a transaction (or series of re- or
granted by a governmental agency) if lated transactions) and later dispose of one
the right has a fixed life of less than of them or if one of them becomes worth- 3) Organizational costs for a partnership.
15 years or is of a fixed amount that less, you cannot recognize any loss on it. In-
except for the section 197 intangible crease the adjusted basis of each remaining The sections below discuss which costs
provisions, would be recoverable amortizable section 197 intangible that you qualify in each of these three areas.
under a method similar to the unit-of- did not dispose of by:
production method of cost recovery.
The amount of the loss not recognized Business Start-Up Costs.
5) An interest under an existing lease or on the disposition Start-up costs are those that you have in set-
sublease of tangible property, ting up an active trade or business, or inves-
MULTIPLIED BY
tigating the possibility of creating or acquir-
6) An interest under an indebtedness that A fraction: ing an active trade or business.
was in existence when the interest was
acquired, ● The numerator of which is the adjusted Start-up costs are amounts you paid or
basis of that remaining intangible as of incurred in connection with an activity en-
7) Sports franchises, the date of its disposition, and gaged in for profit and for the production of
8) A right to service residential mortgages income in anticipation of that activity becom-
● The denominator of which is the total
unless the right is acquired in the acqui- ing an active trade or business.
adjusted basis of all retained amortiza-
sition of a trade or business or a sub- To be amortizable, a start-up cost must
ble section 197 intangibles as of the
stantial part of a trade or business, and meet the following tests.
date of the disposition.
9) Certain transaction costs under a corpo- 1) It must be a cost that would be deducti-
rate organization or reorganization in For more information on dispositions of ble if it were paid or incurred to operate
which any part of a gain or loss is not amortizable section 197 property, see chap- an existing trade or business.
recognized. ter 12 in Publication 535. 2) It must be paid or incurred by you before
you actually begin business operations.
Computer software. Section 197 in- Anti-Churning Rules
tangibles do not include computer software Start-up costs include what you pay for
You cannot convert existing goodwill, going
that is: both investigating a prospective business
concern value, or any other section 197 in-
1) Readily available for purchase by the tangible for which a depreciation or amorti- and getting the business started. For exam-
general public, zation deduction would not have been allow- ple, they may include costs of items such as
able before August 10, 1993, to amortizable the following:
2) Subject to a nonexclusive license, and
property. A survey of potential markets,
3) Not substantially changed. For more information, see chapter 12 in
Publication 535. An analysis of available facilities, labor,
Also, computer software not acquired in the supplies, etc.,
acquisition of a substantial part of a business Anti-abuse rule. A section 197 intangible Advertisements for the opening of the
is not section 197 property. may not be amortized under these rules if business,
Page 60 Chapter 13 AMORTIZATION AND DEPLETION
Salaries and wages for employees who amortize over the life of the partnership, if corporation, only your partnership or corpo-
are being trained, and their your partnership had a fixed life. ration can elect to amortize its start-up or or-
instructors, Partnership organizational costs do not ganizational costs. A partner or shareholder
include syndication fees. That is, they do not cannot make this election.
Travel and other necessary expenses for
include costs connected with the issuing and If you as a partner or shareholder incur
securing prospective distributors,
marketing of interests in the partnership, costs in setting up your partnership or corpo-
suppliers, or customers, and
such as commissions, professional fees, ration, you cannot amortize them. If the part-
Salaries and fees for executives and and printing costs. These costs must be cap- nership or corporation does not reimburse
consultants, or for other professional italized. You cannot depreciate or amortize you for these costs, it cannot amortize them.
services. them. These costs then become part of the basis
of your interest in the business. You can re-
Start-up costs do not include deductible cover them only when you sell your interest
How To Amortize in the partnership or corporation.
interest, taxes, and research and experimen-
tal costs. See Research and Experimental You deduct start-up and organizational costs However, you, as an individual, can elect
Costs, later. in equal amounts over a period of 60 months to amortize the costs you incur to investigate
or more. You can elect a period for start-up an interest in an existing partnership. These
Disposition of business. If you completely costs that is different from the period you expenses qualify as business start-up costs
dispose of your business before the end of elect for organizational costs, as long as if you succeed in acquiring your interest.
the amortization period selected, any de- both are 60 months or more. Once you elect
an amortization period, you cannot change
ferred start-up costs for your business that
it.
Construction Period
you have not deducted can be deducted to
the extent they qualify as a loss from a trade To figure your deductions, you divide Interest and Taxes
or business. your total start-up or organizational costs by You cannot deduct real property construc-
the number of months in the amortization pe- tion period interest or taxes that are paid or
riod. The result is the amount you can deduct accrued in the tax year on property you use
Organizational Costs For a each month. in your trade or business or in an activity you
Corporation The amortization period starts with the conduct for profit. Instead, you must capital-
Corporate organizational costs are those month you begin business operations. You ize these amounts. However, you could
that are incident to the creation of the corpo- can amortize only if you actually go into busi- amortize amounts you paid or incurred
ration. They include the cost of temporary di- ness. For the amortization of organizational before 1987, over a 10-year period.
rectors, organizational meetings, state incor- costs, a partnership or corporation is consid- For more information, see chapter 12 in
poration fees, and accounting services ered to begin business operations when it Publication 535.
related to setting up the organization. They starts the activities for which it is organized.
also include the cost of legal services, such This can happen either before or after the Research and
as drafting the charter, bylaws, terms of the corporate charter is granted or a partnership
original stock certificates, and minutes of or- agreement is signed. A partnership or corpo- Experimental Costs
ganizational meetings. ration will be considered as having begun Research and experimental costs may be
However, you cannot amortize costs of business if its activities have reached the amortized or deducted as current business
issuing and selling stock or securities, such point where the nature of its business opera- costs. You have the choice to deduct the
as commissions, professional fees, and tions can be established. For example, if it costs currently as business expenses or to
printing costs because they are not organi- acquires the assets it needs to operate its treat them as deferred expenses and amor-
zational costs. Costs connected with the business, this may constitute the beginning tize them in equal amounts over a period of
transfer of assets to the corporation also of business activities. not less than 60 months. See chapter 4 for a
cannot be amortized. They must be Making the election. To amortize your discussion of the choice to deduct the costs
capitalized. costs, you must complete Part VI of Form currently.
To qualify for amortization, your organi- 4562 and attach it to your income tax return. The amortization deduction is an election
zational cost must meet all three of the fol- You must also attach to your return a state- that applies to those costs that are chargea-
lowing tests: ment showing the information listed below. If ble to a capital account and that:
1) It must be incident to the creation of the you have both start-up and organizational 1) You paid or incurred in your trade or
corporation. You must have incurred the costs, attach a separate statement to your business, and
cost before the end of the first tax year return for each type of cost. Each statement 2) You are not currently deducting.
in which the corporation is in business. should:
A corporation using the cash method of 1) Show the total start-up or organizational For more information, see section 174 of
accounting may amortize organizational costs that you will amortize, the Internal Revenue Code and the Income
costs incurred within the first tax year, Tax Regulations.
even if it does not pay them in that year. 2) Describe what each is for,
2) It must be chargeable to a capital 3) Give the date each cost was incurred, Bond Premium
account. 4) State the month your business began Bond premium generally is the amount you
3) It must be a cost that could be amor- operations (or the month you acquired pay for a bond that is more than the amount
tized over the life of the corporation, if the business), and the bond issuer will pay upon maturity of the
the corporation had a fixed life. bond. For taxable bonds, bond premium is
5) Specify the number of months in your determined by reference to the amount the
amortization period (not less than 60). bond issuer will pay upon an earlier call date
if it results in a smaller amortizable bond pre-
Organizational Costs For a Attach Form 4562 and accompanying mium attributable to the period ending on the
Partnership statements to your return for the first tax year call date. Bond premium does not include
Partnership organizational costs are those you are in business. The return must be filed any amount attributable to the conversion
costs that are incident to the creation of the by the due date for the return (including any features of a bond.
partnership. To be amortizable, your organi- extensions). The term ‘‘bond,’’ as used in this discus-
zational cost must be chargeable to a capital Partnerships and corporations. If your sion, means any bond, debenture, note, or
account, and it must be one that you could business is organized as a partnership or certificate or other evidence of debt issued
Chapter 13 AMORTIZATION AND DEPLETION Page 61
by a corporation or a government or political preventing the creation or emission of pollu- depletion and percentage depletion. How-
subdivision of a government and bearing in- tants, contaminants, wastes, or heat. It must ever, percentage depletion does not apply to
terest. The term does not include any be appropriately certified by state and fed- oil and gas wells, except for certain ones ex-
obligation: eral certifying authorities. empt from this rule. See Oil and Gas Wells,
If it appears that all or a part of the cost of later.
1) That is your stock in trade or business,
a facility will be recovered from its operation, You must use cost depletion if it is more
2) That would properly be included in your such as through sales of recovered wastes, than percentage depletion for the year.
inventory if on hand at the close of the the federal certifying authority will certify to
taxable year, or that effect, describing the nature of the po- Cost depletion. Figure cost depletion by di-
3) That you held for sale to customers in tential cost recovery. The amortizable cost viding the adjusted basis of the mineral prop-
the ordinary course of your trade or of the facility must be reduced accordingly. erty by the total number of recoverable units
business. For more information on pollution control in the property’s natural deposit. You then
facilities, see chapter 12 in Publication 535. multiply the resulting rate per unit by:
Tax-exempt bonds. You must amortize the 1) The number of units sold and for which
premium on tax-exempt bonds, but you can- Cost of Acquiring a Lease you receive payment during your tax
not deduct the amortizable premium in figur- If you acquire a lease for business purposes, year if you use the cash method of ac-
ing your taxable income. you can recover the cost by amortizing it counting, or
over the term of the lease. The term of the
2) The number of units sold if you use the
Taxable bonds. You can elect to amortize lease for amortization purposes includes all
accrual method of accounting.
the premium on taxable bonds. However, if renewal options (and any other period for
you do not elect to amortize the premium, which the lessee and lessor reasonably ex-
you treat it as part of the basis of your bond. pect the lease to be renewed) if less than Percentage depletion. Figure percentage
75% of the cost is attributable to the term of depletion by multiplying a certain percent-
If you are required or elect to amortize
the lease remaining on the acquisition date. age, specified for each mineral, by your
the premium, you decrease the basis of your
The remaining term of the lease on the ac- gross income from the property during the
bond by the amortizable bond premium. This
quisition date does not include any period for tax year. The deduction for depletion under
will give you the adjusted basis you will use
which the lease may be subsequently re- this method cannot be more than 50%
to figure gain or loss on the sale or redemp-
newed, extended, or continued under an op- (100% for oil and gas property) of your taxa-
tion of the bond.
tion exercisable by the lessee. ble income from the property figured without
A dealer in taxable bonds (or anyone
the deduction for depletion.
who holds them mainly for sale to customers
in the ordinary course of a trade or business, When figuring your percentage depletion
and who would properly include bonds on and the taxable income limit, exclude from
hand in inventory at the close of the tax Depletion your gross income from the property an
year), cannot claim a deduction for amortiza- amount equal to any rents and royalties
If you own mineral property or standing tim-
ble bond premium. Instead the premium is (which are depletable income to the payee)
ber, you can take a deduction for depletion.
part of the cost of the bonds. you pay or incur for the property.
There are two ways of figuring depletion:
See section 75 of the Internal Revenue cost depletion or percentage depletion. You Also, reduce your gross income from the
Code for determining your gross income if must use cost depletion to figure your de- property by the allocable part of any bonus
you are a dealer in tax-exempt bonds. duction on timber property. you paid for a mineral lease or an oil and gas
The depletion deduction is available to lease on the property.
For more information, see Publication
550. you as an owner and an operator only if you Limit for certain oil and gas wells. If
have an economic interest in mineral depos- you are a qualified independent producer or
its or standing timber. For more information royalty owner of oil and gas (see Small pro-
Reforestation Expenses on depletion, see chapter 13 in Publication ducers exemption, later, under Oil and Gas
You can elect to amortize part of the 535. Wells), your deduction for percentage deple-
amounts you spend on forestation or refor- A mineral property is each separate inter- tion is limited to the smaller of:
estation of property held for commercial tim- est you own in each mineral deposit in each 1) Your taxable income from the property
ber production. You can amortize your direct separate tract or parcel of land. A timber figured without the deduction for deple-
costs for planting or seeding, including your property is your economic interest in stand- tion, or
costs for site preparation, seeds or seed- ing timber in each tract or block representing
lings, labor, and tools. Only $10,000 ($5,000 2) 65% of your taxable income (figured
a separate timber account.
for a married individual filing a separate re- without certain deductions).
turn) of these costs in each tax year qualify Alternative minimum tax. Individuals, cor-
for amortization. Each year’s qualifying costs Any amount that cannot be deducted be-
porations, estates, and trusts who claim de-
are amortized over an 84–month period. For cause of the 65% limit can be carried over
pletion deductions may be liable for alterna-
more information, see Reforestation Ex- and added to your depletion allowance
tive minimum tax.
penses in chapter 12 of Publication 535. (before applying any limits) for the following
For more information on individual alter-
year.
native minimum tax, see Form 6251, Alterna-
Pollution Control Facilities tive Minimum Tax–Individuals, and its in-
You can elect to amortize the cost of a certi- structions. For more information on Oil and Gas Wells
corporate alternative minimum tax, see Pub- Generally, percentage depletion is not al-
fied pollution control facility over a period of
60 months. The facility must be used for a lication 542, Tax Information on Corpora- lowed for any oil or gas well. However, an ex-
plant (or other property) that was in opera- tions. For more information on estate and emption from this rule applies to certain oil
trust alternative minimum tax, see Form and gas producers.
tion before 1976.
1041 and its instructions. The use of percentage depletion for oil
Certified pollution control facility. A certi- and gas is usually allowed for domestic gas
fied pollution control facility is depreciable Mineral Property and oil production of small producers.
property that is a new identifiable treatment Mineral property includes oil and gas wells,
facility used to abate or control water or at- mines, and other natural deposits (including Small producers exemption. The small
mospheric pollution or contamination by re- geothermal deposits). There are two ways of producers exemption allows independent
moving, altering, disposing, storing, or figuring depletion on mineral property: cost producers and royalty owners to qualify for a
Page 62 Chapter 13 AMORTIZATION AND DEPLETION
percentage depletion rate of 15% on an av- adjusted by the S corporation for any capital Clay and shale used in making sewer
erage daily production of up to 1,000 barrels. expenditures made for the property and for pipe or bricks, or used as sintered or
(6,000 cubic feet of natural gas is the any change in the shareholder’s interest. burned lightweight aggregates . . . . . . . 71/ 2
equivalent of a barrel of oil.) Each shareholder must separately keep Clay (used or sold for use in making
If you have a part interest in property, records of the shareholder’s pro rata share drainage and roofing tile, flower pots,
your production from that property is in pro- of the adjusted basis in each oil and gas and kindred products), gravel, sand,
portion to your interest. To figure your share property of the S corporation. The share- and stone (other than stone used or
of production for a part interest, such as a holder must reduce the share of the adjusted sold by a mine owner or operator as
net profits interest, see Share of production basis by the depletion taken on the property dimension or ornamental stone) . . . . . . 5
for part interest in chapter 13 of Publication by the shareholder, and use that reduced ad-
Most other minerals, including carbon
535. dioxide produced from a well, and
justed basis to figure cost depletion or the
metallic ores . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
shareholder’s gain or loss on the disposition
Gross income from oil and gas property. of the property by the S corporation. Reduction of percentage depletion
For purposes of percentage depletion, gross
for corporations. The percentage deple-
income from oil and gas property is the
tion deduction of a corporation for iron ore
amount you receive from the sale of the oil or Natural Gas Wells
and coal (including lignite) is reduced by
gas in the immediate vicinity of the well. If
Percentage depletion is allowed for regu- 20% of the excess of:
you do not sell the oil or gas on the property,
lated natural gas and for natural gas sold 1) The percentage depletion deduction for
but manufacture or convert it into a refined
product before sale, or transport it before under a fixed contract or produced from ge- the tax year (figured without regard to
sale, the gross income from the property is opressured brine, regardless of whether you this reduction), over
the ‘‘representative market or field price’’ qualify for the small-producer exemption.
2) The adjusted basis of the property at
(RMFP) of the oil or gas before conversion or the close of the tax year (figured without
transportation. Fixed contract. Income from natural gas the depletion deduction for the tax
If gas is sold after it is removed from the sold under a fixed contract qualifies for per- year).
premises, for a price that is lower than the centage depletion at a rate of 22%.
RMFP, gross income from the property for Natural gas sold under a fixed contract is Gross income from mining. Gross income
percentage depletion purposes is deter- domestic gas that is sold by the producer from a mining property, other than a geother-
mined without regard to the RMFP. under a contract in effect on February 1, mal deposit, is the gross income from ex-
Gross income from the property does not 1975, and at all times thereafter before the tracting ores or minerals from the ground,
include any lease bonuses, advance royal- sale. The price must not be adjusted to re- applying treatment processes, and trans-
ties, or other amounts payable without re- flect the increase in the liability of the seller porting them not more than 50 miles from
gard to production from the property.
for tax because of the change in the law re- the point of extraction to the plant or mill in
garding percentage depletion for gas. Price which a recognized mining treatment pro-
Partnership increases after February 1, 1975, are pre- cess is applied.
For partnership oil and gas properties, the sumed to take the liability into account un- Gross income from mining property also
depletion allowance, whether cost or per- less the taxpayer can demonstrate to the includes the separately stated excise tax re-
centage, must be figured separately by each contrary by clear and convincing evidence. ceived by a mine operator from the sale of
partner and not by the partnership. Each coal to compensate the operator for excise
partner must decide whether to use cost or tax the mine operator must pay to finance
Natural gas from geopressured brine. black lung benefits.
percentage depletion.
The partnership must allocate to each Qualified natural gas from geopressured
partner that partner’s proportionate share of brine is eligible for percentage depletion at Disposal of coal or iron ore. You cannot
the adjusted basis of each partnership do- the rate of 10% if it is produced from a well take a depletion deduction on coal (including
mestic oil or gas property. you began to drill after September 1978, and lignite) or iron ore mined in the United States
Each partner, after receiving the informa- before 1984. that you held for more than 1 year if:
tion from the partnership, must keep this in- 1) You dispose of it and retain an eco-
formation separately. Later, in those sepa-
rate records, the partner must reduce the
Natural and nomic interest, and
share of the adjusted basis of each property Geothermal Deposits 2) The gain is a capital gain.
by the depletion taken on the property each
Mine, wells, and other natural deposits and
year by that partner, and use that reduced Geothermal deposits. Geothermal depos-
geothermal deposits qualify for percentage its located in the United States or its posses-
adjusted basis to figure any cost depletion or
depletion. sions qualify for percentage depletion at the
the partner’s gain or loss if the partnership
later disposes of the property. rate of 15%. A geothermal deposit is a geo-
Reporting the deduction. Deduct oil Mine and other natural deposits. The per- thermal reservoir of natural heat stored in
and gas depletion for a partnership interest centage of your gross income from a natural rocks or in a watery liquid or vapor. It is not
in Part I of Schedule E (Form 1040). deposit that you can deduct as depletion is considered a gas well.
based on the type of deposit. Gross income from a geothermal steam
S Corporation Some of the depletion percentages of well is figured in the same way as for oil and
the more common minerals follow: gas wells. See Gross income from oil and
The depletion allowance is figured sepa- gas property, earlier, under Oil and Gas
rately by each shareholder in the same way Wells.
as a partner in a partnership. Deposits Percent
For an S corporation shareholder to fig- Sulphur, uranium, and, if from deposits in
ure depletion, the S corporation must allo- the United States, asbestos, lead, Lessor’s Gross Income
cate to each shareholder that shareholder’s zinc, nickel, mica, and certain other A lessor’s gross income from the lease of
adjusted basis of each oil or gas property ores and minerals . . . . . . . . . . . . . . . . . . . . . 22 gas, oil, or mineral property for percent-
held by the S corporation. The allocation is Gold, silver, copper and iron ore, and age depletion purposes usually is the total of
made as of the date the corporation acquires certain oil shale if from deposits in the the royalties received from the lease, exclud-
the property. The shareholder’s share of the United States . . . . . . . . . . . . . . . . . . . . . . . . . . 15 ing rentals that are not payment for units of
adjusted basis of the oil and gas property is Coal, lignite, and sodium chloride . . . . . . . 10 mineral produced or to be produced.
Chapter 13 AMORTIZATION AND DEPLETION Page 63
Bonuses and advance royalties. Bonuses Figuring the deduction. Depletion takes 3) Figure the number of units to take into
and advanced royalties are payments that a place when standing timber is cut, however, account by adding the number of units
lessee makes to a lessor as consideration you can figure your depletion deduction acquired during the year to the number
for the lease or for minerals, gas, or oil that when the quantity of cut timber is first accu- of units on hand in the account at the
are to be extracted from leased property. rately measured in the process of exploita- beginning of the year and then adding
Both types of payments are made in ad- tion. At the end of your tax year include in (or subtracting) any correction to the es-
vance of production. If you are the lessor, your closing inventory of products cut from timate of the number of units remaining
your income from bonuses and advanced timber as a cost item any allowable depletion in the account.
royalties is subject to an allowance for on the timber from which the unsold prod-
depletion. ucts are cut. 4) Divide the result of 2) by the result of 3).
For more information on figuring deple- Figure your depletion allowance by This is your depletion unit.
tion on bonuses and advance royalties, see multiplying the number of timber units cut by
chapter 13 in Publication 535. your depletion unit.
Sale or exchange. You can elect, under
Figure your depletion unit as follows:
certain circumstances, to treat the cutting of
Timber 1) Determine your cost or adjusted basis timber as a sale or exchange. See the dis-
You can figure timber depletion only by the of the timber on hand at the beginning cussion under Timber in chapter 22.
cost method. Percentage depletion does not
of the year.
apply to timber. Your depletion is based on
your cost or other basis in the timber. Your 2) Add to the amount determined in 1) the Form T. Attach Form T to your income tax
cost does not include any part of the cost of cost of any units acquired during the return if you claim a deduction for depletion
the land. year and any additions to capital. of timber.
Page 64 Chapter 13 AMORTIZATION AND DEPLETION
comes from operating your trade or busi- If you are unable to collect any part of
ness. All other bad debts are nonbusiness these accounts or notes receivable, the un-
14. bad debts. collectible part is a business bad debt. Ac-
Example. An architect made personal counts or notes receivable valued at fair
Bad Debts loans to several friends who were not cli-
ents. She could not collect on some of these
market value at the time of the transaction
are deductible only at fair market value, even
though that value may be less than face
loans. They are deductible only as nonbusi-
value.
ness bad debts, since the architect was not
You can take a bad debt deduction for
in the business of lending money and the
Introduction loans do not have any relationship to her
these accounts and notes receivable only if
you included the amount owed you in your
If someone owes you money you cannot col- business.
gross income. This applies to amounts owed
lect, you have a bad debt. You can generally you from all sources of taxable income, such
deduct the amount of the bad debt owed you Deductible nonbusiness bad debts. To be as sales, services, rents, and interest.
when you figure your income for tax pur- deductible, nonbusiness bad debts must be If you meet certain requirements, you can
poses. For a bad debt to qualify for the de- totally worthless. You cannot deduct a partly use the nonaccrual-experience method, dis-
duction, there must be a true creditor-debtor worthless nonbusiness bad debt. cussed later. This method allows you to esti-
relationship between you and the person or mate uncollectible amounts. Do not include
organization that owes you the money. Loan or gift. If you lend money to a relative them in your gross income.
There must be a legal obligation to pay you a or friend with the understanding it will be re- Accrual method taxpayers. Accrual
fixed sum of money. You must realize a loss paid, but later forgive the debt, it is a gift, not method taxpayers normally report income as
because of your inability to collect the a loan. You cannot take a bad debt deduc- they earn it. They can take a bad debt deduc-
money owed to you. tion for a gift. There must be a creditor- tion for these receivables when they cannot
To take the bad debt deduction, you must debtor relationship between you and the per- collect what is owed them, if they included
show that the debt is worthless and will re- son or organization that owes you the that amount in income.
main that way. You must have taken reason- money. Cash method taxpayers. Cash method
able steps to collect the debt. However, it is taxpayers normally do not report income un-
not necessary to go to court if you can show Worthless securities. If you own securities til they receive payment. They cannot take a
that a judgment from the court would be un- and they become totally worthless, you can bad debt deduction for payments they have
collectible. Bankruptcy is generally good evi- take a deduction for a loss, but not for a bad not received or cannot collect from these
dence of the worthlessness of at least part debt. See Worthless securities in Publication receivables.
of an unsecured and unpreferred debt. 550.
You can take a bad debt deduction only if Former business. You can deduct a busi-
you have an actual loss of money, or if you ness bad debt that becomes worthless, even
have already reported the amount you were if the debt became worthless after you went
to be paid as income. Business Bad Debts out of business.
A business deducts its bad debts from gross For more information, see Former busi-
Topics income when figuring its taxable income. Un- ness in chapter 14 in Publication 535.
This chapter discusses: like nonbusiness bad debts, you do not de-
● Nonbusiness bad debts duct business bad debts as short-term capi- Insolvency of partner. If your business
tal losses. partnership breaks up and one of your for-
● Business bad debts mer partners is insolvent and cannot pay any
To be deductible as a business bad debt,
● Reporting a bad debt a debt must closely relate to the activity of of the partnership’s debts, you may have to
● Methods of treating business bad debts your business. There must have been a main pay more than your share of the partner-
business reason for you to have entered into ship’s debts. You can take a bad debt de-
duction for any part of the insolvent partner’s
Useful Items the transaction as the creditor.
share of the debts that you are required to
You may want to see: The bad debts of a corporation are al-
pay.
ways business bad debts.
Publication A business bad debt can be either totally
Business loan guarantees. If you guaran-
□ 525 Taxable and Nontaxable Income or partly worthless. If you can collect part,
tee payment of another person’s debt and
but not all, of the amount owed you, you
□ 535 Business Expenses then have to pay it off, you may be able to
have a partly worthless bad debt. If you can-
take a bad debt deduction for your loss. It
□ 550 Investment Income and not collect any of the amount owed you,
does not matter in what capacity you make
Expenses even if you collected some of it in the past, the guarantee, whether as guarantor, en-
you have a totally worthless bad debt. dorser, or indemnitor. To qualify for a bad
Form (and Instructions)
Example. John Smith, an advertising debt deduction, a guarantee you enter into
□ Sch C (Form 1040) Profit or Loss agent, made loans to certain clients to retain must be either entered into with a profit mo-
From Business their business. His main reason for making tive or related to your trade or business, or
□ Sch D (Form 1040) Capital Gains these loans was his business. One of these your employment.
and Losses clients later went bankrupt and could not re- Example. Bob Zayne owns the Zayne
pay him. Since John’s business was the
□ Sch F (Form 1040) Profit or Loss Dress Company. He guaranteed payment of
main reason for making the loan, the debt a $20,000 note for Elegant Fashions, a dress
From Farming
was a business debt and he can take a busi- outlet. Elegant Fashions is one of Zayne’s
ness bad debt deduction. largest clients. Elegant Fashions later files
for bankruptcy and defaults on the loan. Mr.
Nonbusiness Bad Credit transactions. Business bad debts Zayne makes full payment to the bank. He
are mainly the result of credit sales to cus- can take a business bad debt deduction,
Debts tomers. Goods and services customers have since his guarantee was closely related to
There are two kinds of bad debts: business not paid for are shown in your books as ei- his trade or business. He was motivated by
bad debts and nonbusiness bad debts. A t h e r accounts receivable or notes the desire to retain one of his better clients
business bad debt generally is one that receivable. and keep a sales outlet.
Chapter 14 BAD DEBTS Page 65
Business bad debt. You must be able to Partnerships. Partnerships deduct their from gross income the amount recovered up
show that your reason for guaranteeing the business bad debts on line 12 of Form 1065. to the amount of the deduction that did not
debt was closely related to your trade or bus- reduce your tax.
iness. Consider any guarantees you make to See Recoveries in Publication 525 for
protect or improve your job as being closely more information on recovered amounts.
related to your trade or business as an Methods of Treating Example. In 1994, the Willow Corpora-
employee.
For more information on business bad
Business Bad Debts tion had gross income of $158,000, a bad
debt deduction of $3,500, and other allowa-
debts, see chapter 14 in Publication 535. There are two ways to treat uncollectible ble deductions of $49,437. The corporation
Nonbusiness bad debt. You must be amounts: the specific charge-off and nonac- reported on an accrual method of account-
able to show that your reason for making the crual-experience methods. All taxpayers, ex- ing and used the specific charge-off method
guarantee was to protect your investment or cept certain financial institutions, must gen- for bad debts. In 1995, the corporation re-
that you entered the guarantee transaction erally use the specific charge-off method. covers part of the $3,500 deducted in 1994.
with a profit motive. If you make the guaran- You can use the nonaccrual-experience It must include the part recovered in income
tee as a favor to friends and do not receive method if you meet the requirements, dis- for 1995. The entire bad debt deduction re-
any consideration in return, it is a gift. You cussed later. duced the tax on the 1994 corporate return.
cannot take a nonbusiness bad debt For 1995, Willow reports the recovery as
deduction.
Specific Charge-Off ‘‘Other Income’’ on its corporate return.
Example. Henry Lloyd, an officer and Net operating loss (NOL) carryover. If
principal shareholder of the Spruce Corpora-
Method the deduction results in the increase of a car-
tion, guaranteed payment of a bank loan the Using the specific charge-off method, you ryover that has not expired before the begin-
corporation received. The corporation de- deduct specific business bad debts that be- ning of the tax year in which the recovery
faulted on the loan and Henry made full pay- come either partly or totally worthless during takes place, then you treat the deduction as
ment. Because he entered into the guaran- the tax year. having reduced your tax.
tee to protect his investment in the
corporation, Henry can take a nonbusiness Partly worthless debts. You can deduct Property received for a debt. If you re-
bad debt deduction. specific bad debts that are partly uncollecti- ceive property in partial settlement of a debt,
ble. But limit your deduction to the amount reduce the debt by the fair market value of
you charge off on your books during the tax the property received. The remaining debt is
year. You do not have to annually charge off deductible as a bad debt in the year you de-
Reporting a Bad Debt and deduct your partly worthless debts. In- termine it to be worthless and charge it off.
stead you can delay the charge-off until a If you later sell the property received, in-
How you report a bad debt depends on
later year. You can wait until more of the clude any gain or loss from the sale in gross
whether it is a nonbusiness or business bad
debt becomes worthless, or you collect all income. The gain is not a recovery of a bad
debt.
you can and it is totally worthless. You can- debt previously deducted without tax benefit.
not, however, deduct any part of a debt after For information on the sale of an asset, see
Nonbusiness bad debts. Deduct nonbusi-
the year it becomes totally worthless. chapter 21.
ness bad debts as short-term capital losses
Deduction disallowed. Usually, you
on Schedule D (Form 1040). There are limits
can take a partial bad debt deduction only in Bankruptcy claim. You may only deduct as
on how much of your capital losses you may
the year you make the charge-off on your a bad debt the difference between the
deduct. For a discussion of these limits, see
books. However, the Internal Revenue Ser- amount owed to you by a bankrupt entity and
Treatment of Capital Losses in chapter 22.
vice may not allow your deduction. If the the amount you received from the distribu-
In Part I, line 1 of Schedule D, enter the
debt then becomes partly worthless in a later tion of its assets.
name of the debtor, and ‘‘statement at-
tax year, you can deduct the amount you
tached,’’ in column (a), and the amount of
charge off in that year, plus the amount Net operating loss. A bad debt deduction
the bad debt in column (f). Use a separate
charged off in the earlier year. The charge- can produce or increase a net operating
line for each bad debt.
off in the earlier year, unless reversed on loss. If you have a net operating loss one
If you deduct a nonbusiness bad debt,
your books, fulfills the charge-off require- year, you can carry it back or forward to
fully explain it on your tax return. Attach a
ment for the later year. other tax years and deduct it from income
statement to your return that contains:
you earned in those years. As a result, a bad
1) A description of the debt, including the Totally worthless debts. Deduct a totally debt deduction that contributes to a net op-
amount and date it became due, worthless bad debt only in the tax year it be- erating loss may lower taxes in the year to
2) The name of the debtor and any busi- comes totally worthless. The deduction for which you carry the net operating loss.
ness or family relationship between you the debt must not include any amount de- See chapter 20 for information on operat-
and the debtor, ducted in an earlier tax year when the debt ing losses.
was only partly worthless.
3) The efforts you made to collect the You do not have to make an actual
debt, and charge-off on your books to claim a bad debt Nonaccrual-Experience
4) Why you decided the debt was deduction for a totally worthless debt. How- Method
worthless. ever, you may want to do so. If a debt you If you use an accrual method of accounting
claim to be totally worthless is not charged and qualify under certain rules, you can use
Business bad debts. Use the following off on your books and the IRS later rules that the nonaccrual-experience method of ac-
guide to find where to report your business the debt is only partly worthless, you will not counting for bad debts. Under this method,
bad debt deductions. be allowed a deduction for that debt in that you do not have to accrue income that you
Individuals. Deduct a bad debt from op- tax year. A deduction of a partly worthless expect to be uncollectible.
erating a trade or business on line 9 of bad debt is limited to the amount actually The nonaccrual-experience method ap-
Schedule C (Form 1040). Deduct a bad debt charged off. plies only to amounts to be received (ac-
from operating a farm business, on line 34 of counts receivable) for services you per-
Schedule F (Form 1040). Recovery of a bad debt. If you deduct a formed. You cannot use it if you charge
Corporations. Corporations deduct bad bad debt and later recover (collect) all or part interest or penalties on late payments. If you
debts on line 15 of Form 1120, line 15 of of it, you may have to include the amount you determine, based on your experience, that
Form 1120–A, or line 10 of Form 1120S. recover in gross income. You can exclude your accounts receivable are uncollectible,
Page 66 Chapter 14 BAD DEBTS
do not include them in gross income for the 1) You accrue the full amount due as gross Treat each system as a separate method
tax year. However, only the methods allowed income at the time you provide the ser- of accounting. You generally cannot change
by the service may be used in determining vices, and from one system to the other without IRS
the uncollectible amounts. consent.
Generally, you need the consent of the
Performing services. You can use the 2) You treat the discount allowed for early IRS to change to either system under the
nonaccrual-experience method only for payment as an adjustment to gross in- nonaccrual-experience method from a differ-
amounts, earned by performing services, come in the year of payment. ent accounting method.
that you would otherwise include in income. For more information on the separate re-
You cannot use this method for amounts ceivable system, see section 1.448-2T of the
owed to you from activities such as lending Income Tax Regulations. For more informa-
Methods to determine uncollectible
money, selling goods, or acquiring receiv- tion on the periodic system, see Notice 88-
amount. You can apply the nonaccrual-ex-
ables or other rights to receive payments. 51, 1988-1 C.B. 535.
perience method under either a separate re-
Interest cannot be charged on amounts ceivable system or a periodic system. Under
due. Generally, you cannot use the nonac- the separate receivable system, apply the
crual-experience method for amounts due nonaccrual-experience method separately
on which you charge interest or a late pay- to each account receivable. Under the peri-
ment penalty. However, do not treat offering odic system, apply the nonaccrual-experi-
a discount for early payment as charging in- ence method to the total of the qualified ac-
terest or a late payment penalty if: counts receivable at the end of your tax year.
Chapter 14 BAD DEBTS Page 67
● Reimbursement of employee business Tax Home
expenses
15. To deduct travel expenses, you must first de-
termine the location of your tax home.
Useful Items Generally, your tax home is your regular
Travel, You may want to see: place of business or post of duty, regardless
of where you maintain your family home. It
Entertainment, Publication
□ 463 Travel, Entertainment, and Gift
includes the entire city or general area in
which your business or work is located. If you
and Gift Expenses have more than one regular place of busi-
ness, your tax home is your main place of
□ 535 Business Expenses
Expenses □ 917 Business Use of a Car
business. If you do not have a regular or a
main place of business because of the na-
□ 1542 Per Diem Rates ture of your work, then your tax home may be
the place where you regularly live. See No
Form (and Instructions) main place of business or work, later.
Important Changes □ W–2 Wage and Tax Statement If you do not fit any of these categories,
you are considered a transient (an itinerant)
for 1995 □ Sch C (Form 1040) Profit or Loss and your tax home is wherever you work. As
From Business a transient, you cannot claim a travel ex-
Standard mileage rate. The standard mile-
age rate for the cost of operating your car in □ Sch C–EZ (Form 1040) Net Profit pense deduction because you are never
1995 is 30 cents per mile for all business From Business considered away from home.
miles. □ 2106 Employee Business Expenses
Main place of business or work. If you
□ 2106–EZ Unreimbursed Employee
have more than one place of work, you
Receipts for business expenses. Begin- Business Expenses
should use the following factors to deter-
ning October 1, 1995, you must have re-
□ 4562 Depreciation and Amortization mine your main place of business or work:
ceipts for amounts that are $75 (rather than
$25) or more for certain business expenses. 1) The total time you ordinarily spend
See Recordkeeping. working in each area,
Travel Expenses 2) The degree of your business activity in
If you temporarily travel away from your tax each area, and
Important Reminders home, you can use this section to determine
if you have deductible travel expenses. This
3) The relative amount of your income
from each area.
Travel expenses paid for others. You can- section includes the definitions of ‘‘tax
not deduct travel expenses you pay or incur home’’ and ‘‘temporary’’ and a discussion of
for a spouse, dependent, or other individual Example. You live in Cincinnati where
different types of travel expenses. The sec-
who accompanies you (or your employee) you have a seasonal job for 8 months and
tion then discusses the rules for travel inside
on business travel unless the travel satisfies earn $15,000. You work the remaining 4
and outside the United States and deducti-
specific requirements. See Travel expenses months in Miami, also at a seasonal job, and
ble expenses of attending a convention.
for another individual. earn $4,000. Cincinnati is your main place of
work because you spend most of your time
Travel expenses defined. For tax pur- there and earn most of your income there.
Club dues. Generally, you are not allowed a poses, travel expenses are ordinary and
deduction for dues (including initiation fees) necessary expenses that you pay while trav-
for membership in any club organized for No main place of business or work. You
eling away from home for your business or
business, pleasure, recreation, or other so- may have a tax home even if you do not have
profession. An ordinary expense is one that
cial purpose. See Club dues and member- a regular or main place of work. Your tax
is common and accepted in your field of bus-
ship fees. home may be the home where you regularly
iness, trade, or profession. A necessary ex-
live. If you do not have a regular or main
pense is one that is helpful and appropriate
place of business or work, use the following
Business meals and entertainment. Gen- to your business. An expense does not have
three factors to see if you have a tax home.
erally, you can deduct only 50% of your busi- to be indispensable to be considered neces-
ness meals and entertainment expenses. sary. However, you cannot deduct expenses 1) You have part of your business in the
to the extent they are lavish or extravagant. area of your main home and use that
You will find examples of deductible home for lodging while doing business
travel expenses in Table 15–1. there.
Introduction 2) You have living expenses at your main
This chapter covers certain expenses of Traveling away from home. You are trav- home that you duplicate because your
business owners. However, if you reimburse eling away from home if: business requires you to be away from
employees for business expenses that they 1) Your duties require you to be away from that home.
incur on your behalf, this chapter applies to the general area of your tax home (de- 3) You have not left the area in which both
your employees also. fined next) substantially longer than an your traditional place of lodging and
ordinary day’s work, and your main home are located; you have a
Topics 2) You need to get sleep or rest to meet member or members of your family liv-
This chapter discusses: the demands of your work while away ing at your main home; or you often use
● Business-related travel away from from home. that home for lodging.
home
This rest requirement is not satisfied by If you meet all three factors above, your
● Entertainment merely napping in your car. You do not have tax home is the home where you regularly
● Business gifts to be away from your tax home for a whole live, and you may be able to deduct travel ex-
day or from dusk to dawn as long as your re- penses. If you meet only two of the factors,
● Local business transportation lief from duty is long enough to get neces- you may have a tax home depending on all
● Recordkeeping sary sleep or rest. the facts and circumstances. If you meet
Page 68 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
only one factor, you are a transient; you do Table 15-1. Deductible Travel Expenses
not have a tax home and you cannot deduct
travel expenses.
Expense Description
Temporary assignment or job. Although Transportation The cost of travel by airplane, train, or bus between your
you regularly work or carry on your business home and your business destination.
activities within the city or general area of
Taxi, commuter bus, Fares for these and other types of transportation between the
your tax home, you may have to work or con-
and limousine airport or station and your hotel, or between the hotel and
duct business at another location. It may not
your work location away from home.
be practical to return home from this other
location at the end of each day’s work. Baggage and The cost of sending baggage and sample or display material
If your assignment away from your main shipping between your regular and temporary work locations.
place of work is temporary, your tax home
does not change. You are considered to be Car The costs of operating and maintaining your car when travel-
away from home for the whole period, and ing away from home on business. You may deduct actual ex-
your travel expenses are deductible. Gener- penses or the standard mileage rate, including business-re-
ally, a temporary assignment in a single loca- lated tolls and parking. If you lease a car while away from
tion is one that is realistically expected to home on business, you can deduct business-related ex-
penses only.
last (and does in fact last) for one year or
less. Lodging The cost of lodging if your business trip is overnight or long
However, if your assignment is indefi- enough to require you to get substantial sleep or rest to prop-
nite, that location becomes your new tax erly perform your duties.
home and you cannot deduct your travel ex-
penses while there. Your assignment or job Meals The cost of meals only if your business trip is overnight or
is considered indefinite if it is realistically ex- long enough to require you to stop to get substantial sleep or
pected to last for more than one year, re- rest. Includes amounts spent for food, beverages, taxes, and
gardless of whether it actually exceeds one related tips.
year.
Cleaning Cleaning and laundry expenses while away from home over-
night.
Additional information. See chapter 1 of
Publication 463 for more information on tax Telephone The cost of business calls while on your business trip, includ-
home. ing business communication by fax machine or other commu-
nication devices.
What Are Travel Tips Tips you pay for any expenses in this chart.
Expenses?
Once you have determined that you are trav- Other Other similar ordinary and necessary expenses related to
your business travel such as public stenographer’s fees and
eling away from your tax home, you can de-
computer rental fees.
termine what travel expenses are
deductible.
Records. When you travel away from home generally cannot deduct his or her travel ex- Standard Meal Allowance
on business, you should keep records of all penses. You can only deduct the travel ex- You generally can deduct a standard amount
the expenses you incur. You can use a log, penses you pay or incur for such an accom- for your daily meals and incidental expenses
diary, notebook, or any other written record panying individual if that individual: while you are traveling away from home on
to keep track of your expenses. The types of 1) Is your employee, business. Incidental expenses include costs
expenses you need to record, along with for laundry, cleaning, and tips for services. In
supporting documentation, are described 2) Has a bona fide business purpose for this chapter, the term ‘‘standard meal allow-
later in this chapter under Recordkeeping. the travel, and ance’’ refers to meals and incidental
3) Would otherwise be allowed to deduct expenses.
Deductible travel expenses. Deductible the travel expenses. This method is an alternative to the ac-
travel expenses include those ordinary and tual cost method. It allows you to deduct a
necessary expenses you incur while travel- set amount, depending on where you travel,
For a bona fide business purpose to ex-
ing away from home on business. The type instead of keeping records of actual meal ex-
ist, you must prove a real business purpose
of expense you can deduct depends on the penses. If you use the standard meal allow-
for the individual’s presence. Incidental ser- ance, you still must keep records to prove
facts and your circumstances. Table 15–1 vices, such as typing notes or assisting in en- the time, place, and business purpose of
summarizes the expenses you may be able tertaining customers, are not enough to war- your travel. See the recordkeeping rules for
to deduct. rant a deduction. travel, explained later under Recordkeeping.
You can use that table as a general
guideline. The expenses are explained in New business. You cannot deduct Who can use the standard meal allow-
more detail in chapter 1 of Publication 463. amounts you spend for travel to conduct a ance. You can use the standard meal allow-
You may have other deductible travel ex- general search for, or preliminary investiga- ance whether you are an employee or self-
penses that are not listed there, depending tion of, a new business. For more informa- employed.
on the facts and your circumstances. tion on how to treat these costs, see Going You can use the standard meal allow-
Into Business in chapter 4. If you moved your ance whether or not you are reimbursed for
Travel expenses for another individual. If home in 1995 because you started a new your traveling expenses. If you are not reim-
a spouse, dependent, or other individual business, you may qualify for a moving ex- bursed or if you are reimbursed under a
goes with you (or your employee) on a busi- pense deduction. For information, see Publi- nonaccountable plan for meal expenses,
ness trip or to a business convention, you cation 521, Moving Expenses. you can deduct only 50% of the standard
Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES Page 69
meal allowance. If you are reimbursed under 1) Directly involves moving people or your stay for a vacation, made a nonbusi-
an accountable plan and you are deducting goods by airplane, barge, bus, ship, ness side trip, or had other nonbusiness ac-
amounts that are more than your reimburse- train, or truck, and tivities, you can deduct your business-re-
ments, you can deduct only 50% of the ex- lated travel expenses. These expenses
2) Regularly requires you to travel away
cess amount. include the travel costs of getting to and
from home and, during any single trip,
from your business destination and any busi-
usually involves travel to areas eligible
Amount of standard meal allowance. The ness-related expenses at your business
for different standard meal allowance
standard meal allowance is $26 a day for destination.
rates.
most areas in the United States. Other loca- Example. You work in Atlanta and take a
tions in the United States are designated as business trip to New Orleans. On your way
If this applies to you, you can claim a $32 a
high-cost areas, qualifying for higher stan- home, you stop in Mobile to visit your par-
day standard meal allowance ($36 for travel
dard meal allowances. ents. You spend $630 for the 9 days you are
outside the continental United States).
Table 2 in Publication 463 shows the lo- away from home for travel, meals, lodging,
Using the special rate for transportation
cations qualifying for rates of $30, $34, or and other travel expenses. If you had not
workers eliminates the need for you to deter-
$38 a day for travel on or after January 1, stopped in Mobile, you would have been
mine the standard meal allowance for every
1995. gone only 6 days and your total cost would
area where you stop for sleep or rest. If you
If you travel to more than one location in have been $580. You can deduct $580 for
choose to use the special rate for any trip,
one day, use the rate in effect for the area your trip, including the cost of round-trip
however, you must continue to use the spe-
where you stop for sleep or rest. If you work transportation to and from New Orleans. The
cial rate (and not use the regular standard
in the transportation industry, however, see cost of your meals is subject to the 50% limit
meal allowance rates) for all trips you take
Special rate for transportation workers, later on meal expenses.
that year.
in this section.
Example. You regularly live and work as Travel for less than 24 hours. If you are Trip Primarily for
an independent contractor in Chicago. You not traveling for the entire 24-hour day, you Personal Reasons
sometimes travel overnight to Des Moines must prorate the standard meal allowance. If your trip was primarily for personal rea-
for business. You must keep receipts to You may do so by dividing the day into 6- sons, such as a vacation, the entire cost of
prove the amount of your lodging expense. hour quarters. The 6-hour quarters are: the trip is a nondeductible personal expense.
You can claim the standard meal allowance However, you can deduct any expenses you
for Des Moines, $30. You are subject to the 1) Midnight to 6 a.m.,
have while at your destination that are di-
50% limit on meal and entertainment 2) 6 a.m. to noon, rectly related to your business.
expenses. A trip to a resort or on a cruise ship may
3) Noon to 6 p.m., and
Standard meal allowance for areas be a vacation even if the promoter adver-
outside the continental United States. 4) 6 p.m. to midnight. tises that it is primarily for business. The
The previously mentioned standard meal al- scheduling of incidental business activities
lowance rates do not apply to travel in You can claim one-fourth of the full day stan- during a trip, such as viewing videotapes or
Alaska, Hawaii, or any other locations dard meal allowance for each 6-hour quarter attending lectures dealing with general sub-
outside the continental United States. The of the day during any part of which you are jects, will not change what is really a vaca-
federal per diem rates for these locations are traveling away from home. tion into a business trip.
published monthly in the Maximum Travel You may also prorate the standard meal
Per Diem Allowances for Foreign Areas. allowance by using any method that is con- Part of Trip Outside
You can purchase the publication from sistently applied and is in accordance with
the: reasonable business practice.
the United States
If part of your trip is outside the United
Superintendent of Documents Example. You live and work in your own States, use the rules described later under
U.S. Government Printing Office consulting business in Los Angeles. You go Travel Outside the United States for that part
to San Francisco on a temporary assign- of the trip. For the part of your trip that is in-
P.O. Box 371954
ment. You leave home at 8 a.m. on March side the United States, use the rules in this
Pittsburgh, PA 15250–7954
23. Your assignment is completed on March section. Travel outside the United States
26. You arrive home at 4 p.m. on that day. does not include travel from one point in the
You can also order it by calling the Govern-
You are considered to be traveling for 3 1/ 2 United States to another point in the United
ment Printing Office at (202)512–1800 (not a
days (a 3/ 4 day on March 23 + 2 full days + a States. The following discussion can help
toll-free number). 3
/ 4 day on March 26). Your standard meal al- you determine whether your trip was entirely
The 1995 Foreign Per Diem Rates are
lowance is $133 (3 1/ 2 × $38) while on this within the United States.
also available on the Internet. If you have a
assignment.
computer and a modem, you may access
this information via the following addresses: Public transportation. If you travel by pub-
Travel in the lic transportation, any place in the United
gopher: States where that vehicle makes a sched-
dosfan.lib.uic.edu.port 70
United States uled stop is a point in the United States.
Universal Resource Locator (URL): The following discussion applies to travel in Once the vehicle leaves the last scheduled
gopher://dosfan.lib.uic.edu/ the United States. For this purpose, the stop in the United States on its way to a point
Mosaic or WWW: United States includes the 50 states and the outside the United States, you apply the
http://dosfan.lib.uic.edu/dosfan.html District of Columbia. The treatment of your rules under Travel Outside the United
travel expenses depends on how much of States.
Once on the Department of State Foreign your trip was business related and on how
Example. You fly from New York to Pu-
Affairs Network (DOSFAN), select Travel much of your trip occurred within the United
erto Rico with a scheduled stop in Miami.
and Consular Information. States.
You return to New York nonstop. The flight
from New York to Miami is in the United
Special rate for transportation workers. Trip Primarily for Business States, so only the flight from Miami to Pu-
You may be able to use a special standard You can deduct all your travel expenses if erto Rico is outside the United States. The
meal allowance if you work in the transporta- your trip was entirely business related. If your return trip is all outside the United States, as
tion industry. You are in the transportation in- trip was primarily for business and, while at there are no scheduled stops between Pu-
dustry if your work: your business destination, you extended erto Rico and New York.
Page 70 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
Private car. Travel by private car in the Tuesday and flew to New York. On Trip Primarily for Vacation
United States is travel between points in the Wednesday, you flew from New York to
United States, even when you are on your Paris, arriving the next morning. On If your travel was primarily for vacation, or for
way to a destination outside the United Thursday and Friday, you had business investment purposes, and you spent some
States. discussions, and from Saturday until time attending brief professional seminars or
Tuesday, you were sightseeing. You a continuing education program, the entire
Example. You travel by car from Denver
flew back to New York, arriving Wednes- cost of the trip is a nondeductible personal
to Mexico City and return. Your travel from
day afternoon. On Thursday, you flew expense. You may, however, deduct your re-
Denver to the border and from the border
back to Denver. Although you were gistration fees and any other expenses in-
back to Denver is travel in the United States
away from your home in Denver for curred that were directly related to your
and the rules in this section apply. The rules
under Travel Outside the United States ap- more than a week, you were not outside business.
ply to your trip from the border to Mexico City the United States for more than a week. Example. You are a doctor practicing
and back to the border. This is because the day of departure medicine and are a member of a profes-
does not count as a day outside the sional association. The association spon-
Private plane. If you travel by private plane, United States. You can deduct your cost sored a 2-week trip to two foreign countries
any trip, or part of a trip, for which both your of the round-trip flight between Denver with three professional seminars in each
takeoff and landing are in the United States and Paris. You can also deduct the cost country. Each seminar was 2 hours long and
is travel in the United States. This is true of your stay in Paris for Thursday and was held in a different city. You also made an
even if part of your flight is over a foreign Friday while you conducted business. optional side trip to a well-known tourist at-
country. However, you cannot deduct the cost of traction in each of the countries visited. At
Example. You fly nonstop from Seattle your stay in Paris from Saturday through
the end of the trip you received a Certificate
to Juneau. Although the flight passes over Tuesday because those days were
of Continuing Education in Medicine.
Canada, the trip is considered to be travel in spent on nonbusiness activities.
You paid the cost of airfare, hotel accom-
the United States. 3) You were outside the United States modations, meals, a special escort, trans-
more than a week, but you spent less portation to and from hotels, and tips. No
Travel Outside than 25% of the total time you were part of the cost you paid was specifically
outside the United States on nonbusi- stated for the seminars, which were ar-
the United States ness activities. For this purpose, count ranged for you by the sponsoring profes-
If any part of your business travel is outside both the day your trip began and the day sional association.
the United States, some of your deductions it ended. Your participation in the professional
for the cost of getting to and from your desti- Example. You flew from Seattle to seminars did not change what was essen-
nation may be limited. For this purpose, the Tokyo, where you spent 14 days on bus- tially a vacation into a business trip. Your
United States includes the 50 states and the iness and 5 days on personal matters. travel expenses were not related primarily to
District of Columbia. You then flew back to Seattle. You your business. You had no other expenses
How much of your travel expenses you spent one day flying in each direction. that were directly for your business. You can-
can deduct depends in part upon how much Because only 5/ 21 (less than 25%) of not deduct the cost of your trip as an ordi-
of your trip outside the United States was
your total time abroad was for nonbusi- nary and necessary business expense.
business related.
ness activities, you can deduct as travel
See chapter 1 of Publication 463 for in-
expenses what it would have cost you to
formation on luxury water travel.
make the trip if you had not engaged in Conventions
any nonbusiness activity. The amount You can deduct your travel expenses when
Travel Entirely for Business you can deduct is the cost of the round- you attend a convention if you can show that
If you travel outside the United States and trip plane fare and 16 days of meals your attendance benefits your trade or busi-
you spend the entire time on business activi- (subject to the 50% limit), lodging, and ness. You cannot deduct the travel ex-
ties, all your travel expenses of getting to other related expenses. penses for your family. If the convention is
and from your business destination are
4) You can establish that a personal vaca- for investment, political, social, or other pur-
deductible.
tion was not a major consideration, poses unrelated to your trade or business,
In addition, even if you do not spend your
even if you have substantial control over you cannot deduct the expenses. Nonbusi-
entire time on business activities, your trip is
arranging the trip. ness expenses, such as social or sightsee-
considered entirely for business and you can
deduct all of your business-related travel ex- ing expenses, are personal expenses and
penses if you meet at least one of the follow- If you do not meet any of these condi- are not deductible.
ing four conditions. tions, you may still be able to deduct some of Your appointment or election as a dele-
your expenses. See Travel Primarily for Busi- gate does not, in itself, entitle you to or de-
1) You did not have substantial control prive you of a deduction. Your attendance
ness, next.
over arranging the trip. You are not con- must be connected to your own trade or
sidered to have substantial control business.
merely because you have control over Travel Primarily for Business
the timing of your trip. If you traveled outside the United States pri-
A self-employed person is generally Convention agenda. The agenda of the
marily for business purposes, but spent 25%
regarded as having substantial control convention does not have to deal specifi-
or more of your time on nonbusiness activi-
over arranging business trips. cally with your official duties or the responsi-
ties, your travel expense deductions are lim-
bilities of your position or business. It is
2) You were outside the United States for a ited unless you meet one of the four condi-
enough if the agenda is so related to your ac-
week or less, combining business and tions listed earlier under Travel Entirely for
tive trade or business and your responsibili-
nonbusiness activities. One week Business. If your deductions are limited, you
ties that attendance for a business purpose
means seven consecutive days. In must allocate your travel expenses of getting
is justified.
counting the days, do not count the day to and from your destination between your
you leave the United States, but count business and nonbusiness activities to de-
the day you return to the United States. termine your deductible amount. These Foreign conventions. See chapter 1 of
Example. You traveled to Paris pri- travel allocation rules are discussed in chap- Publication 463 for information on conven-
marily for business. You left Denver on ter 1 of Publication 463. tions held outside the North American area.
Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES Page 71
your business is not entertainment. Gener- Taxes and tips relating to a business
Entertainment ally, to deduct an entertainment-related
meal, you or your employee must be present
meal or entertainment activity are included in
the amount that is subject to the 50% limit.
Expenses when the food or beverages are provided. Expenses such as cover charges for admis-
A meal expense includes the cost of sion to a nightclub, rent paid for a room in
You may be able to deduct business-related
food, beverages, taxes, and tips for the which you hold a dinner or cocktail party, or
entertainment expenses you have for enter-
meal. the amount paid for parking at a sports arena
taining a client, customer, or employee.
To be deductible, the expense must be No double deduction allowed for are subject to the 50% limit. However, the
both ordinary and necessary. An ordinary ex- meals. You cannot claim the cost of your cost of transportation to and from a business
meal as an entertainment expense if you are meal or a business-related entertainment
pense is one that is common and accepted
also claiming the cost of your meal as a activity is not subject to the 50% limit.
in your field of business, trade, or profession.
travel expense. If you pay or incur an expense for goods
A necessary expense is one that is helpful
and appropriate for your business. An ex- Deduction may depend on your type and services consisting of meals, entertain-
of business. Your kind of business may de- ment, and other services (such as lodging or
pense does not have to be indispensable to
termine if a particular activity constitutes en- transportation), you must allocate that ex-
be considered necessary.
tertainment. For example, if you are a dress pense between the cost of meals and en-
In addition, the entertainment expense
tertainment and the cost of the other ser-
must meet one of two tests: designer and have a fashion show to intro-
vices. You must have a reasonable basis for
1) Directly-related test, or duce your new designs to store buyers, the
making this allocation. For example, you
show generally is not considered entertain-
2) Associated test. must allocate your expenses if a hotel in-
ment because fashion shows are typical in
cludes one or more meals in its room charge,
your business. But, if you are an appliance
You must also meet the requirements dis- or if you are provided with one per diem
distributor and hold a fashion show for the
cussed later under Recordkeeping. amount to cover both your lodging and meal
spouses of your retailers, the show generally
Even if you meet all the requirements for expenses.
is considered entertainment.
claiming a deduction for entertainment ex- Taking turns paying for meals or en-
penses, the amount you can deduct may be Application of 50% limit. The 50% limit on
tertainment. Expenses are not deductible meal and entertainment expenses applies if
limited. Generally, you can deduct only 50%
when a group of business acquaintances the expense is otherwise deductible and is
of your unreimbursed entertainment ex-
take turns picking up each other’s meal or not covered by one of the exceptions dis-
penses. This limit is discussed later under
entertainment checks without regard to cussed in chapter 3 of Publication 535. The
50% Limit.
whether any business purposes are served. 50% limit also applies to activities that are
Club dues and membership fees. You are not a trade or business. It applies to meal
not allowed a deduction for dues (including Expenses not considered entertainment. and entertainment expenses incurred for the
initiation fees) for membership in any club or- Entertainment does not include supper production of income including rental or roy-
ganized for business, pleasure, recreation, money you give your employees working alty income. It also applies to the cost of
or other social purpose. This applies to any overtime, a hotel room you keep for your em- meals included in deductible educational
membership organization if one of its princi- ployees while on business travel, or a car expenses.
pal purposes is to conduct entertainment ac- used in your business (even if it is used for
tivities for members or their guests, or to pro- routine personal purposes, such as commut- When to apply the 50% limit. You apply
vide members or their guests with access to ing to and from work). However, if you pro- the 50% limit after determining the amount
entertainment facilities. vide the use of a hotel suite or a car to your that would otherwise qualify for a deduction.
The purposes and activities of a club, not employee who is on vacation, this is en- You first determine the amount of meal and
its name, will determine whether or not the tertainment of the employee. entertainment expenses that would be de-
dues are deductible. You cannot deduct ductible under the rules discussed in this
dues paid to country clubs, golf and athletic Additional information. For more informa- chapter.
clubs, airline clubs, hotel clubs, and clubs tion on entertainment expenses, including If you are self-employed, figure the limit
operated to provide meals under circum- discussions of the directly-related and asso- on Schedule C. If you file Schedule C–EZ,
stances generally considered to be condu- ciated tests, see chapter 2 of Publication enter the total amount of your business ex-
cive to business discussions. penses on line 2. You can only include 50%
463.
of your meal and entertainment expenses in
Entertainment. Entertainment includes any that total.
activity generally considered to provide en- 50% Limit Example 1. You spend $100 for a busi-
tertainment, amusement, or recreation. Ex- In general, you can deduct only 50% of your ness-related meal. If $40 of that amount is
amples include entertaining guests at night- business-related meal and entertainment not allowable because it is considered lavish
clubs; at social, athletic, and sporting clubs; expenses. This limit applies to employees or and extravagant, the remaining $60 is sub-
at theaters; at sporting events; on yachts; or their employers, and to self-employed per- ject to the 50% limit. Your deduction cannot
on hunting, fishing, vacation, and similar sons (including independent contractors) or be more than $30 (.50 × $60).
trips. You cannot deduct expenses for en- their clients, depending on whether the ex- Example 2. You purchase two tickets to
tertainment to the extent they are lavish or penses are reimbursed. a concert and give them to a client. You pur-
extravagant. If you buy a ticket to an en- The 50% limit applies to business meals chased the tickets through a ticket agent.
tertainment event for a client, you generally or entertainment expenses incurred while: You paid $150 for the two tickets, which had
can only take into account the face value of a face value of $60 each ($120 total). Your
the ticket even if you paid a higher price. 1) Traveling away from home (whether deduction cannot be more than $60 (.50 ×
Entertainment also may include meeting eating alone or with others) on $120).
personal, living, or family needs of individu- business,
als, such as providing food, a hotel suite, or a 2) Entertaining business customers at your
car to business customers or their families.
A meal as a form of entertainment.
place of business, a restaurant, or other
location, or
Business Gift
Entertainment includes the cost of a meal
you provide to a customer or client whether 3) Attending a business convention or re- Expenses
the meal is a part of other entertainment or ception, business meeting, or business If you give business gifts in the course of
by itself. A meal sold in the normal course of luncheon at a club. your trade or business, you can deduct the
Page 72 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
cost subject to the limits and rules in this an entertainment expense. However, if you Commuting expenses. You cannot deduct
section. give a customer packaged food or bever- the costs of taking a bus, trolley, subway, or
ages that you intend the customer to use at a taxi, or driving a car between your home and
Limit on business gifts. You can deduct no later date, treat it as a gift expense. your main or regular place of work. These
more than $25 for business gifts you give di- If you give tickets to a theater perform- costs are personal commuting expenses.
rectly or indirectly to any one person during ance or sporting event to a business cus- You cannot deduct commuting expenses no
your tax year. A gift to a company that is in- tomer and you do not go with the customer matter how far your home is from your regu-
tended for the eventual personal use or ben- to the performance or event, you can choose lar place of work. You cannot deduct com-
efit of a particular person or a limited class of to treat the tickets as either a gift or en- muting expenses even if you work during the
people will be considered an indirect gift to tertainment expense, whichever is to your commuting trip.
that particular person or to the individuals advantage. Example. You had a telephone installed
within that class of people who receive the You can change your treatment of the in your car. You sometimes use that tele-
gift. tickets at a later date, but not after the time phone to make business calls while commut-
A gift to the spouse of a business cus- allowed for the assessment of income tax. In ing to and from work. Sometimes business
tomer or client is an indirect gift to the cus- most instances, this assessment period associates ride with you to and from work,
tomer or client. However, if you have an in- ends 3 years after the due date of your in- and you have a business discussion in the
dependent bona fide business connection come tax return. But if you go with the cus- car. These activities do not change the trip’s
with the spouse, the gift generally will not be tomer to the event, you must treat the cost of expenses from commuting to business. You
considered an indirect gift to the other the tickets as an entertainment expense. cannot deduct your commuting expenses.
spouse. It will, however, be considered an in- You cannot choose, in this case, to treat the Parking fees. Fees you pay to park your
direct gift to the other spouse if it is intended tickets as a gift expense. car at your place of business are nondeduct-
for that spouse’s eventual use or benefit. ible commuting expenses. You can, how-
These rules also apply to gifts you give to ever, deduct business-related parking fees
any other family member. when visiting a customer or client.
If you and your spouse both give gifts, Local Transportation Hauling tools or instruments. If you
both of you are treated as one taxpayer. It
does not matter whether you have separate Expenses haul tools or instruments in your vehicle
while commuting to and from work, this does
businesses, are separately employed, or This section discusses expenses you can not make your commuting costs deductible.
whether each of you has an independent deduct for local business transportation. It However, you can deduct additional costs,
connection with the recipient. If a partner- also discusses deductions you can take for such as renting a trailer that you tow with
ship gives gifts, the partnership and the part- the business use of your car, whether you your vehicle for carrying equipment to and
ners are treated as one taxpayer. use it for business-related local transporta- from your job.
tion or when traveling away from home over- Advertising display on car. The use of
Incidental costs. Incidental costs, such as night on business. your car to display material that advertises
engraving on jewelry, or packaging, insuring, Local transportation expenses include your business does not change the use of
and mailing, are generally not included in de- the ordinary and necessary expenses of get- your car from personal use to business use.
termining the cost of a gift for purposes of ting from one workplace to another in the If you use this car for commuting or other
the $25 limit. course of your business or profession when personal uses, you cannot deduct your ex-
A related cost is considered incidental you are traveling within your tax home area. penses for such uses. Commuting or per-
only if it does not add substantial value to the Tax home is defined earlier. sonal expenses are not deductible.
gift. For example, the cost of gift wrapping is The following discussion applies to you if
considered an incidental cost. However, the you have a regular or main job away from Office in the home. If you have an office in
purchase of an ornamental basket for pack- your residence. If your principal place of bus- your home that qualifies as a principal place
aging fruit is not considered an incidental iness is in your home, see Office in the of business, you can deduct your daily
cost of packaging if the basket has a sub- home, later. transportation costs between your home
stantial value compared to the value of the Local transportation expenses also in- and another work location in the same trade
fruit. clude the cost of getting from your home to a or business. (See Publication 587, Business
temporary workplace when you have one or Use of Your Home, for information on deter-
Exceptions. The following items are not in- more regular places of work. These tempo- mining if your home office qualifies as a prin-
cluded in the $25 limit for business gifts. rary workplaces can be either within the area cipal place of business.)
1) An item that costs $4 or less and: of your tax home or outside that area. If your home office does not qualify as a
a) Has your name clearly and perma- Local business transportation does not principal place of business, follow the gen-
nently imprinted on the gift, and include expenses you have while traveling eral rules explained earlier.
away from home overnight. Transportation
b) Is one of a number of identical items expenses you can deduct while traveling
you widely distribute. Examples of deductible local transporta-
away from home overnight are discussed
Examples include pens, desk sets, and tion. The following examples illustrate when
earlier in this chapter under Travel
plastic bags and cases. you can deduct local transportation ex-
Expenses.
penses based on the location of your work
2) Signs, display racks, or other promo- Local business transportation expenses and your home.
tional material to be used on the busi- include the cost of transportation by air, rail,
ness premises of the recipient. bus, taxi, etc., and the cost of driving and Example 1. Your office is in the same
maintaining your car. city as your home. You cannot deduct the
Employee achievement awards. Em- You can deduct your expenses for local cost of transportation between your home
ployee achievement awards are not treated business transportation, including the busi- and your office. This is a personal commut-
as gifts. For information on the requirements ness use of your car, if the expenses are or- ing expense. You can deduct the cost of
you must meet in order to deduct the cost of dinary and necessary. An ordinary expense round-trip transportation between your office
these awards, see Bonuses and Awards in is one that is common and accepted in your and a client’s or customer’s place of
chapter 2 of Publication 535. field of trade, business, or profession. A nec- business.
essary expense is one that is helpful and ap- Example 2. You regularly work in an of-
Gift or entertainment. Any item that might propriate for your business. An expense fice in the city where you live. You attend a
be considered either a gift or an entertain- does not have to be indispensable to be con- one-week training session at a different of-
ment expense generally will be considered sidered necessary. fice in the same city. You travel directly from
Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES Page 73
after June 30, 1993. The vehicle must meet
certain requirements, and you do not have to
use it in your business to qualify for the credit
or the deduction. For more information, see
chapter 15 of Publication 535.
Car expense records. Whether you use ac-
tual expenses or the standard mileage rate,
you must keep records to show when you
started using your car for business and the
cost or other basis of the car. Your records
must also show the business miles and the
total miles you drove your car during the
year.
Actual expenses. If you deduct actual
expenses, you must keep records of the
costs of operating the car. If you lease a car,
you must also keep records of that cost.
Actual Expenses
If you choose to deduct actual expenses,
you can deduct the cost of the following
items:
Depreciation Lease fees Rental fees
Garage rent Licenses Repairs
Gas Oil Tires
Insurance Parking fees Tolls
Business and personal use. If you use
your car for both business and personal pur-
poses, you must divide your expenses be-
tween business and personal use.
Example. You are a contractor and drive
your car 20,000 miles during the year:
12,000 miles for business use and 8,000
miles for personal use. You can claim only
60% (12,000 ÷ 20,000) of the cost of oper-
ating your car as a business expense.
Interest on car loans. If you are self-em-
ployed and use your car in that business, see
chapter 16.
Taxes paid on your car. You cannot de-
your home to the training location and return nondeductible commuting expenses. Al- duct luxury or sales taxes, even if you use
each day. You can deduct the cost of your though you cannot deduct the costs of these your car 100% for business. Luxury and
daily round-trip transportation between your trips, you can deduct the costs of going from sales taxes are part of your car’s basis and
home and the training location. one client or customer to another. may be recovered through depreciation. If
you are self-employed and use your car in
Example 3. Your principal place of busi- Illustration of local transportation. Figure that business, see chapter 18 for more
ness is in your home. (The rules for ‘‘princi- 15–A illustrates the rules for when you can information.
pal place of business’’ are discussed in Pub- deduct local transportation expenses when
lication 587, Business Use of Your Home. ) you have a regular or main job away from Fines and collateral. Fines and collateral
You can deduct the round-trip business-re- your residence. You may want to refer to it for traffic violations are not deductible.
lated local transportation expenses between when deciding whether you can deduct your
your qualifying home office and your client’s local business transportation expenses. Leasing a car. If you lease a car that you
or customer’s place of business. You must, use in your business, you can deduct the part
however, distinguish between business and of each lease payment that is for the use of
personal transportation.
Car Expenses the car in your business. You cannot deduct
If you use your car for business purposes, any part of a lease payment that is for com-
Example 4. You have no regular office, you may be able to deduct car expenses. muting or for any other personal use of the
and you do not have an office in your home. You generally can use one of two methods car. You must spread any advance pay-
In this case, the location of your first busi- to figure your expenses: actual expenses or ments over the entire lease period. You can-
ness contact is considered your office. the standard mileage rate. not deduct any payments you make to buy a
Transportation expenses between your car even if the payments are called lease
home and this first contact are nondeduct- Note. You may be entitled to a tax credit payments.
ible commuting expenses. In addition, trans- for an electric vehicle or a deduction from If you lease a car that you use in your
portation expenses between your last busi- gross income for a part of the cost of a business for 30 days or more, you may have
ness contact and your home are also clean-fuel vehicle that you place in service to include in your income an amount called
Page 74 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
an ‘‘inclusion amount.’’ For more informa- b) A section 179 deduction. Note: These rates do not apply for any
tion, see chapter 3 of Publication 917. year in which the actual expenses method
Two or more cars. If you own two or was used.
Depreciation and section 179 deduc- more cars that are used for business at the
tions. If you use your car for business pur- same time, you cannot take the standard Depreciation
poses, you may be able to recover its cost by mileage rate for the business use of any car. Year Rate per Mile
claiming a depreciation or section 179 de- However, you may be able to deduct a part 1994 – 1995 . . . . . . . . . . . . . . . . . . . . . . . 12 cents
duction. The amount you may claim depends of the actual expenses for operating each of 1992 – 1993 . . . . . . . . . . . . . . . . . . . . . . . 111/ 2 cents
on the year you placed the car in service and the cars. See Actual Car Expenses in chap- 1989 – 1991 . . . . . . . . . . . . . . . . . . . . . . . 11 cents
the amount of your business use. 1988 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101/ 2 cents
ter 2 of Publication 917 for information on
For more information, see the instruc- 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 cents
how to figure your deduction.
tions for Form 4562. Also see chapter 2 of 1986 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 cents
You are not using two or more cars for
Publication 917 for a detailed discussion of 1983 – 1985 . . . . . . . . . . . . . . . . . . . . . . . 8 cents
business at the same time if you alternate
these deductions. 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71/ 2 cents
using (use at different times) the cars for
1980 – 1981 . . . . . . . . . . . . . . . . . . . . . . . 7 cents
business.
Standard Mileage Rate The following examples illustrate the For tax years before 1990, the rates ap-
Instead of figuring actual expenses, you may rules for when you can and cannot use the plied to the first 15,000 miles. For tax years
be able to use the standard mileage rate to standard mileage rate for two or more cars. after 1989, the depreciation rate applies to
figure the deductible costs of operating your
Example 1. Marcia, a salesperson, owns all business miles.
car, van, pickup or panel truck for business
purposes. You can use the standard mileage a car and a van that she alternates using for Example. In 1991, you bought a car for
rate only for a car that you own. For 1995, calling on her customers. She can take the exclusive use in your business. The car cost
the standard mileage rate is 30 cents a mile standard mileage rate for the business mile- $14,000. From 1991 through 1995, you used
for all business miles. age of the car and the van. the standard mileage rate to figure your car
If you choose to take the standard mile- expense deduction. You drove your car
Example 2. Tony uses his own pickup 18,750 miles in 1991, 17,200 miles in 1992,
age rate, you cannot deduct actual operat- truck in his landscaping business. During
ing expenses. These include depreciation, 18,100 miles in 1993, 16,300 miles in 1994,
1995, he traded in his old truck for a newer and 17,600 miles in 1995. The depreciation
maintenance and repairs, gasoline (includ-
one. Tony can take the standard mileage allowed is figured as follows:
ing gasoline taxes), oil, insurance, and vehi-
rate for the business mileage of both the old
cle registration fees. Year Miles × Rate Depreciation
and the new trucks.
You generally can use the standard mile-
1991 18,750 × .11 $ 2,063
age rate regardless of whether you are reim- Example 3. Chris owns a repair shop
1992 17,200 × .111/ 2 1,978
bursed and whether or not any reimburse- and an insurance business. He uses his
1993 18,100 × .111/ 2 2,082
ment is more or less than the amount figured pickup truck for the repair shop and his car
1994 16,300 × .12 1,956
using the standard mileage rate. See Reim- for the insurance business. No one else uses
1995 17,600 × .12 2,112
bursement of Employee Expenses, later. either the pickup truck or the car for business
purposes. Chris can take the standard mile- Total depreciation $10,191
Choosing the standard mileage rate. If age rate for the business use of the truck
you want to use the standard mileage rate and the car. At the end of 1995, your adjusted basis in the
for a car, you must choose to use it in the first car is $3,089 ($14,000 – $10,191).
Example 4. Maureen owns a car and a
year you place the car in service in business.
van that are both used in her housecleaning
Then in later years, you can choose to use
business. Her employees use the car and
the standard mileage rate or actual
expenses. she uses the van to travel to the various cus- Recordkeeping
If you choose to use the standard mile- tomers. Maureen cannot take the standard This section discusses the written records
age rate, you are considered to have made mileage rate for the car or the van. This is be- you need to keep if you plan to deduct an ex-
an election not to use the accelerated cost cause both vehicles are used in Maureen’s pense discussed in this chapter. By keeping
recovery system (ACRS) or the modified ac- business at the same time. She must use ac- timely and accurate records, you will have
celerated cost recovery system (MACRS). tual expenses for both vehicles. support to show the IRS if your tax return is
This is because the standard mileage rate al- ever examined. Or, you may require proof of
lows for depreciation. You also cannot claim Parking fees and tolls. In addition to using expenses for which you are reimbursing your
the section 179 deduction. If you change to the standard mileage rate, you can deduct employees under an accountable plan, as
the actual expenses method in a later year, any business-related parking fees and tolls. discussed later under Adequate Accounting.
but before your car is considered fully depre- (Parking fees that you pay to park your car at If you reimburse employees for business
ciated, you have to estimate the useful life of your place of work are nondeductible com- expenses that they incur on your behalf, this
the car and use straight line depreciation. muting expenses.) section applies to your employees as well as
For information on how to figure that depre- to you, the employer. Your employees must
ciation, see the exception in Methods of de- submit the proper records to you, and you
Basis of car. To figure gain or loss on the
preciation under Depreciation Deduction in must retain these records to support your
disposition of a car that you used for busi-
Publication 917. deductible business expenses. If your em-
ness, you must figure its adjusted basis by ployees have questions on what records are
subtracting from the basis any depreciation needed, you will find the information in this
Standard mileage rate not allowed. You
(including any section 179 or clean-fuel vehi- section helpful in answering their questions.
cannot use the standard mileage rate if you:
cle deduction) that you claimed. If you used
1) Do not own the car, the standard mileage rate for the business Proof needed. You must be able to prove
2) Use the car for hire (such as a taxi), use of your car, depreciation was included in (substantiate) your deductions for travel, en-
that rate. The rate of depreciation that was tertainment, business gift, and transporta-
3) Operate two or more cars at the same
allowed in the standard mileage rate is tion expenses. You should keep adequate
time (as in fleet operations), or
shown in the chart that follows. This depreci- records or have sufficient evidence that will
4) Claimed a deduction for the car in an ation reduces the basis of your car (but not support your own statement. Estimates or
earlier year using: below zero) in figuring its adjusted basis approximations do not qualify as proof of an
a) ACRS or MACRS depreciation, or when you dispose of it. expense.
Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES Page 75
Table 15-2. Elements To Prove Certain Business Expenses
Element to Expense
be
proved Travel Entertainment Gift Transportation (Car)
(1) (2) (3) (4) (5)
Amount Amount of each Amount of each separate expense. Incidental Cost of gift. 1) Amount of each
separate expense for expenses such as taxis, telephones, etc., separate expense
travel, lodging, and may be totaled on a daily basis. including cost of the
meals. Incidental car,
expenses may be 2) Mileage for each
totaled in reasonable business use of the
categories, such as car, and
taxis, daily meals for 3) Total miles for the
traveler, etc. tax year.
Time Date you left and Date of entertainment. For meals or Date of gift. Date of the expense or
returned for each trip, entertainment directly before or after a use.
and number of days for business discussion, the date and duration of
business. the business discussion.
Place Name of city or other Name and address or location of place of Not applicable. Name of city or other
designation. entertainment. Type of entertainment if not designation if
otherwise apparent. Place where business applicable.
discussion was held if entertainment is
directly before or after a business discussion.
Description Not applicable. Not applicable. Description of gift. Not applicable.
Business Business reason for Business reason or the business benefit Business reason Business reason for
Purpose travel or the business gained or expected to be gained. Nature of for giving the gift the expense or use of
benefit gained or business discussion or activity. or the business the car.
expected to be gained. benefit gained or
expected to be
gained.
Business Not applicable. Occupations or other information—such as Occupation or Not applicable.
Relationship names or other designations—about persons other
entertained that shows their business information—
relationship to you. If all people entertained such as name or
did not take part in business discussion, other
identify those who did. You must also prove designation—
that you or your employee was present if about recipient
entertainment was a business meal. that shows his or
her business
relationship to
you.
Timely recordkeeping. You do not need to travel, local business transportation, en- Separating expenses. Each separate pay-
write down the elements of every expense at tertainment, and gifts. These factors are dis- ment usually is considered a separate ex-
the time of the expense. However, a record cussed in more detail in chapter 5 of Publica- pense. If you entertain a customer or client
of the elements of an expense or of a busi- tion 463. at dinner and then go to the theater, the din-
ness use made at or near the time of the ex- To deduct these expenses, you must be ner expense and the cost of the theater tick-
pense or use, supported by sufficient docu- able to prove the elements listed in column 1 ets are two separate expenses. You must re-
mentary evidence, has more value than a of the chart. You prove these elements by cord them separately in your records.
statement prepared later when generally having the information and receipts (where Totaling items. You may make one daily
there is a lack of accurate recall. A log main- needed) for the expenses listed in columns entry for reasonable categories such as taxi
tained on a weekly basis, which accounts for 2, 3, 4, or 5, whichever apply. fares, telephone calls, gas and oil, or other
use during the week, is considered a record incidental travel costs. Meals should be in a
made at or near the time of the expense or Adequate records. You should keep the
separate category. You should include tips
use. proof you need for these items in an account
with the costs of the services you received.
book, diary, statement of expense, or similar
Expenses of a similar nature occurring
Duplicate information. You do not have to record, and keep adequate documentary ev-
during the course of a single event are con-
record information in your account book or idence (such as receipts, canceled checks,
other record that duplicates information or bills), that together will support each ele- sidered a single expense. For example, if
shown on a receipt as long as your records ment of an expense. Documentary evidence during entertainment at a cocktail lounge,
and receipts complement each other in an is explained in more detail later in this dis- you pay separately for each serving of re-
orderly manner. cussion. Written evidence has considerably freshments, the total expense for the re-
more value than oral evidence alone. freshments is treated as a single expense.
Chart that shows proof needed. Table
15–2 summarizes the factors needed to Documentary evidence. You generally
prove the elements of your expenses for must have documentary evidence, such as
Page 76 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
receipts, canceled checks, or bills, to sup- recorded elsewhere at or near the time of You have different options for reimburs-
port your expenses. However, this evidence the expense and be available to fully prove ing your employees for business-related ex-
is not needed if: that element of the expense. penses. These include:
1) You have meal or lodging expenses for 1) Reimbursing them for their actual ex-
travel away from home and you use a Inadequate records. If you do not have ad- penses, as discussed throughout this
per diem allowance method for claiming equate records to prove an element of an ex- chapter,
these expenses, pense, then you must prove the element by: 2) Reimbursing them for business use of
2) You use the standard mileage rate to 1) Your own statement, whether written or their cars:
claim business car expenses, oral, containing specific information a) At a fixed amount per mile of business
3) Your expense, other than lodging, is about the element, and travel,
less than $25 (less than $75 for ex- 2) Other supporting evidence sufficient to b) With a fixed and variable amount de-
penses incurred after September 30, establish the element. termined by a cents-per-mile rate plus
1995), or a flat amount (based on a standard
4) You have a transportation expense for Additional information for the IRS. vehicle and the area) as explained
which a receipt is not readily available. You may have to provide additional informa- later under Car or mileage al-
tion to the IRS to clarify or to establish the lowances, or
Accountable plans and per diem and accuracy or reliability of information con- c) By any other method that is consist-
mileage allowances are discussed later tained in your records, statements, testi- ently applied and in accordance with
under Reimbursement of Employee mony, or documentary evidence before a de- reasonable business practices.
Expenses. duction is allowed. 3) Using the meals only allowance (dis-
Adequate evidence. Documentary evi- cussed later) to reimburse meals and in-
dence ordinarily will be considered adequate How long to keep records and receipts. cidental expenses and reimbursing ac-
if it shows the amount, date, place, and es- You must keep proof to support your claim to tual lodging expenses,
sential character of the expense. a deduction as long as your income tax re-
For example, a hotel receipt is enough to 4) Using the regular federal per diem rate
turn can be examined. Generally, it will be (discussed later),
support expenses for business travel if it
necessary for you to keep your records for 3
has: 5) Using the high-low method (discussed
years from the date you file the income tax
1) The name and location of the hotel, later), or
return on which the deduction is claimed. A
return filed early is considered as filed on the 6) Reimbursing them under any other
2) The dates you stayed there, and
due date. method that is acceptable to the IRS.
3) Separate amounts for charges such as
lodging, meals, and telephone calls. You should tell your employees what
Additional information. See chapter 5 of
method of reimbursement you use and what
Publication 463 for more information on re-
A restaurant receipt is enough to prove records they must submit.
cordkeeping, including a discussion on how
an expense for a business meal if it has:
to prove each type of expense discussed in
1) The name and location of the No reimbursement. Your employees are
this chapter.
restaurant, not reimbursed or given an allowance for
their expenses if you pay them a salary or
2) The number of people served, and commission with the understanding that they
3) The date and amount of the expense.
Reimbursement of will pay their own expenses. In this situation,
you do not have a reimbursement or allow-
If a charge is made for items other than food Employee Expenses ance arrangement.
and beverages, the receipt must show that
this is the case. You generally can deduct the amount you re- Chart that shows how to report. Table 15-
Canceled check. A canceled check, to- imburse your employees for expenses dis- 3 explains what you report on Form W–2 and
gether with a bill from the payee, ordinarily cussed in this chapter. The amount and what the employee reports on Form 2106.
establishes the cost. However, a canceled manner in which you can deduct these ex- The instructions for the forms have more in-
check by itself does not prove a business ex- penses depend in part on whether you reim- formation on completing them.
pense without other evidence to show that it burse the expenses under an accountable
was for a business purpose. plan or a nonaccountable plan.
This section explains the two types of
Accountable Plans
To be an accountable plan, your reimburse-
Business purpose. A written statement of plans, how per diem allowances simplify
ment or allowance arrangement must re-
the business purpose of an expense is gen- proving the amount of your expenses, and
quire an employee to meet all three of the
erally needed. However, the degree of proof the tax treatment of these reimbursements
following rules:
varies according to the circumstances in and expenses.
each case. If the business purpose of an ex- 1) The employee’s expenses must have a
pense is clear from the surrounding circum- Reimbursement, allowance, or advance. business connection — that is, he or
stances, a written explanation is not needed. A reimbursement or other expense allow- she must have paid or incurred deducti-
ble expenses while performing services
Example. A sales representative who ance arrangement is a system or plan that
as your employee,
calls on customers on an established sales you use to pay, substantiate, and recover the
route does not have to submit a written ex- expenses, advances, reimbursements, and 2) Your employee must adequately ac-
planation of the business purpose for travel- amounts charged to you by your employees count to you for these expenses within a
ing that route. for employee business expenses. It can also reasonable period of time, and
be a system used to keep track of amounts 3) Your employee must return any excess
Confidential information. Confidential in- you pay through an agent or a third party. Ar- reimbursement or allowance within a
formation relating to an element of a deducti- rangements include per diem and mileage reasonable period of time.
ble expense, such as the place, business allowances. If a single payment includes
purpose, or business relationship, need not both wages and an expense reimbursement, ‘‘Adequate accounting’’ and ‘‘returning
be put in your account book, diary, or other you must specifically identify to the em- excess reimbursements’’ are discussed
record. However, the information has to be ployee the amount of the reimbursement. later.
Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES Page 77
An excess reimbursement or allow- Table 15-3. Reporting Travel, Entertainment, and
ance is any amount you pay that is more Gift Expenses and Reimbursements
than the business-related expenses that
your employee adequately accounted for to
you. See Returning Excess Reimburse- Type of Reimbursement Employer Employee
ments, later, for information on how to han- (or Other Expense Reports on Shows on
dle these excess amounts. Allowance) Arrangement Form W–2 Form 21061
The definition of reasonable period of
Accountable
time depends on the facts of the situation.
The IRS will consider it reasonable for your Actual expense reimburse- Not reported Not shown if expenses do
employee to: ment not exceed reimbursement
1) Receive an advance within 30 days of Adequate accounting
the time he or she has an expense, and excess returned
2) Adequately account for the expense Actual expense reimburse- Excess reported as wages All expenses (and
within 60 days after it was paid or in- ment in box 1. Amount reimbursements reported
curred, and adequately accounted for on Form W–2, box 13) only
3) Return any excess reimbursement to Adequate accounting and is reported only in box 13— if some or all of the excess
you within 120 days after the expense return of excess it is not reported in box 1. expenses are claimed.2
was paid or incurred. both required but Otherwise, form is not filed.
excess not returned
If you give your employee a periodic
Per diem or mileage All expenses and
statement (at least quarterly) that asks him Not reported
allowance (up to federal reimbursements only if
or her to either return or adequately account
rate) excess expenses are
for outstanding advances and the employee
Adequate accounting claimed.2 Otherwise, form
complies within 120 days of the statement, is not filed.
the IRS will consider the amount adequately and excess returned
accounted for or returned within a reasona-
ble period of time. Per diem or mileage Excess reported as wages All expenses (and
allowance (exceeds in box 1. Amount up to the reimbursements equal to
federal rate) federal rate is reported the federal rate) only if
Employee meets accountable plan rules.
Adequate accounting up to only in box 13—it is not expenses in excess of the
If your employee meets the three rules for reported in box 1. federal rate are claimed.2
accountable plans, do not include any reim- the federal rate only
Otherwise, form is not filed.
bursements in his or her income in box 1 of and excess not returned
Form W–2.
Expenses subject to 50% limit. If you Nonaccountable
reimburse meal or entertainment expenses Either adequate accounting Entire amount is reported All expenses2
under an accountable plan, you (the em- or return of excess, or both, as wages in box 1.
ployer) may be subject to the 50% limit. Ex- not required by plan
ceptions to the 50% limit are discussed in
chapter 3 of Publication 535. No reimbursement Normal reporting of wages, All expenses2
etc.
Keeping records. If you require that your 1
employees account to you and return any Employees may be able to use Form 2106-EZ. The qualifications are listed on the form.
2
Any allowable business expense is carried to line 20 of Schedule A (Form 1040) and deducted as a
excess advances or allowances (and the miscellaneous itemized deduction.
employees meet these requirements), you
must keep the records and supporting docu-
ments given to you by your employees to Reimbursement of nondeductible ex- amount) that qualifies as an accountable
prove the deductions on your return for the penses. If you reimburse your employees plan, two facts affect your reporting:
allowances and reimbursements you paid under your accountable plan for expenses
them. 1) The federal rate for the area where your
related to your business that are not deducti- employees traveled, and
ble as employee business expenses, the
Employee does not meet accountable 2) Whether the allowance or your employ-
amounts you pay the employee for the non-
plan rules. You may reimburse an em- ees’ actual expenses were more than
deductible expenses are treated as paid
ployee under your accountable plan but only the federal rate.
under a nonaccountable plan.
part of the employee’s expenses may meet
all three rules. Example. Your reimbursement arrange- For this purpose, the federal rate can be fig-
If you reimburse expenses under an oth- ment reimburses your employees for travel ured by using any one of three methods:
erwise accountable plan but your employee expenses they incurred while away from
does not return, within a reasonable period home on business, and for meal expenses 1) The regular federal per diem rate (dis-
of time, any reimbursement for which he or cussed later),
they paid when working late at the office,
she did not adequately account to you, then even though they are not away from home. 2) The high-low method (discussed later),
only the amount for which the employee did The part of the arrangement that reimburses or
adequately account is considered as paid the employees for the nondeductible meals
under an accountable plan. The remaining 3) The standard meal allowance (dis-
while working late at the office is treated as a cussed earlier under What Are Travel
expenses are treated as having been reim-
second arrangement. The payments under Expenses?).
bursed under a nonaccountable plan (dis-
this second arrangement are treated as paid
cussed later).
under a nonaccountable plan.
If you pay your employees an advance or The following discussions explain how to
allowance that is higher than the federal per handle the reimbursements depending upon
diem or standard mileage rate, see Re- Per diem allowances. If you reimburse em- how the amount of the per diem allowance
turning Excess Reimbursements, later. ployees by a per diem allowance (daily compares to the federal rate.
Page 78 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
Per diem allowance LESS than or expenses and voluntarily returning excess If the IRS finds that your travel allowance
EQUAL to the federal rate. If the per diem reimbursements to you. practices are not based on reasonably accu-
allowance is less than or equal to the federal rate estimates of travel costs, including rec-
rate, you do not include the allowance in box Adequate Accounting ognition of cost differences in different ar-
1 of the employee’s Form W–2. eas, your employees will not be considered
One of the three rules (listed earlier) for a re-
Example. In April you send Jeremy on a to have accounted to you. In this case, they
imbursement or other expense allowance ar-
2-day business trip to Boston. The federal may have to prove their expenses to the IRS.
rangement to qualify as an accountable plan
rate in Boston is $139 per day. As required Allowance for meals. These rules also
was that employees adequately account to
by your accountable plan, Jeremy accounts apply if you reimburse an employee for meal
you for their expenses. Employees ade-
for the time (dates), place, and business pur- expenses only or give a separate per diem
quately account by giving you documentary
pose of the trip. You reimburse him $139 a allowance for meals and incidental ex-
evidence of their mileage, travel, and other
day ($278 total) for living expenses. penses. Your reimbursement or allowance
employee business expenses, along with a
You do not include any of the reimburse- must not be more than the standard meal al-
statement of expense, an account book, a
ment on his Form W–2. lowance. A per diem allowance is paid sepa-
diary, or a similar record in which they en-
Per diem allowance MORE than the rately for meals and incidental expenses if
tered each expense at or near the time they
federal rate. If you pay an amount that is you furnish lodging in kind, pay a meal allow-
had it. Documentary evidence includes re-
more than the federal rate, you must include ance plus the actual cost of lodging, or pay
ceipts, canceled checks, and bills. See Ta-
the amount of the per diem allowance up to the hotel, motel, etc., directly for employee
ble 15–2 for the aspects or elements of each
the federal rate in box 13 (code L) of your lodging. A per diem allowance is also paid
expense that employees must prove.
employee’s Form W–2. This amount is not separately for meals and incidental ex-
Employees must account for all amounts penses if you do not have a reasonable be-
taxable. In addition, you must include the received from you during the year as ad-
amount of the allowance that is more than lief that an employee incurred lodging ex-
vances, reimbursements, or allowances for penses, such as when the employee stays
the federal rate in box 1 of your employee’s business use of their cars, travel, entertain-
Form W–2. Your employee must report this with friends or relatives or the employee
ment, gifts, or any other expenses. This in- sleeps in the cab of his or her truck.
part of the allowance as if it were wage cludes amounts that they charged to you by
income. credit card or other method. They must give
Regular federal per diem rate. The regular
Example. Laura lives and works in Aus- you the same type of records and supporting
federal per diem rate is the highest amount
tin. You send her to Dallas for 2 days on busi- information that they would have to give to
that the federal government will pay to its
ness. You pay the hotel directly for Laura’s the IRS if the IRS questioned a deduction on employees for lodging, meal, and incidental
lodging and reimburse Laura $40 a day ($80 their return. Employees must pay back the expenses (or meal and incidental expenses
total) for meals and incidental expenses. amount of any reimbursement or other ex- only) while they are traveling away from
The federal rate for Dallas is $34 per day. pense allowance for which they do not ade- home in a particular area. The rates are dif-
You must include the $12 excess over quately account or that exceeds the amount ferent for different locations. You must use
the federal rate [($40 – $34) × 2] in box 1 of for which they accounted. the rate in effect for the area where your em-
Laura’s Form W–2. You also show $68 ($34
ployee stops for sleep or rest. You should
a day × 2) in box 13 of her Form W–2. This Per diem allowance or reimbursement. have these rates available. You can get Pub-
amount is not included in Laura’s income. You can have your employees prove the lication 1542, which gives the rates in the
amount of their travel expenses by using a continental United States for the current
Car or mileage allowances. The rules gov- per diem allowance amount. If you reimburse year.
erning car or mileage allowances you pay your employees for lodging, meal, and inci- The federal rates for meals and inciden-
your employees are similar to those gov- dental expenses at a fixed amount per day of tal expenses are the same as those rates
erning per diem allowances. You can pay a business travel, that amount is called a per discussed earlier under Standard Meal
car or mileage allowance at the standard diem allowance. Allowance.
mileage rate (discussed earlier), pay at an- The term ‘‘incidental expenses’’ in-
other rate per mile, or base the payment on a cludes, but is not limited to, laundry ex- High-low method. This is a simplified
fixed and variable rate allowance (as de- penses, cleaning and pressing expenses, method of computing the federal per diem
scribed later). and fees and tips for persons who provide rate for travel within the continental United
Generally, the amount considered services, such as food servers and luggage States. It eliminates the need to keep a cur-
proven by a car or mileage allowance cannot handlers. Incidental expenses do not include rent list of the per diem rate in effect for each
exceed the standard mileage rate. Your em- taxicab fares or the costs of telegrams or city in the continental United States.
ployees must prove to you the time (dates), telephone calls. Under the high-low method, the per diem
place, and business purpose for using their A per diem allowance satisfies the ade- amount for travel during 1995 is $152 for cer-
cars. quate accounting requirements for the tain locations. All other areas have a per
Fixed and variable rate allowance amount in question if: diem amount of $95. The areas eligible for
(FAVR). You can choose to reimburse your
1) You reasonably limit payments of the the $152 per diem amount under the high-
employees for their car expenses by paying
travel expenses to those that are ordi- low method for all of the year or the portion
them a cents-per-mile rate to cover their va-
nary and necessary in the conduct of of the year specified in parentheses under
riable operating costs (such as gas, oil, etc.)
your trade or business, the key city name are listed in Table 6 in
plus a flat amount to cover their fixed costs
chapter 6 of Publication 463.
(such as depreciation, insurance, etc.). This 2) The allowance is similar in form to and
is called a FAVR allowance. See Revenue not more than the federal per diem (that
Procedure 94–73 in Internal Revenue Bulle- is, the allowance varies based on where
Returning Excess
tin 1994–52 for information on using a FAVR and how long an employee was Reimbursements
allowance. traveling), Under an accountable plan, you must require
your employees to return any excess reim-
3) The employee is not related to you (as
Employer’s plan. You make the decision bursement or other expense allowances for
defined under Standard Meal Allowance
whether to use an accountable plan or a business expenses to you. Excess reim-
in chapter 1 of Publication 463), and
nonaccountable plan when reimbursing your bursement means any amount for which the
employees. An employee cannot turn your 4) The time, place, and business purpose employee did not adequately account within
nonaccountable plan into an accountable of the travel are proved, as explained a reasonable period of time. For example, if
plan by voluntarily accounting to you for the earlier under Recordkeeping. an employee received a travel advance and
Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES Page 79
did not spend all the money on business-re- amounts will be treated as being paid under provide an adequate accounting of these ex-
lated expenses, or did not have proof of all a nonaccountable plan: penses to your client. If you do not account
his or her expenses, the employee has an to your client for these expenses, you must
excess reimbursement. 1) Excess reimbursements an employee
include any reimbursements or allowances
fails to return, and
Unproven amount. If an employee does in income. You must keep adequate records
not prove that he or she actually traveled on 2) Reimbursements of nondeductible ex- of these expenses regardless of whether
each day for which he or she received a per penses related to your business. See you account to your client for such
diem or mileage allowance (proving the ele- Reimbursement of nondeductible ex- expenses.
ments described in Table 15–2), he or she penses earlier under Accountable If you do not separately account for and
must return this unproven amount of the al- Plans. seek reimbursement for meals and en-
lowance within a reasonable period of time. tertainment in connection with providing ser-
If the employee fails to do this, you must re- An arrangement that repays an em- vices for a client, you are subject to the 50%
port as income in box 1 of the employee’s ployee by reducing the amount reported as limit on such expenses. See 50% Limit,
Form W–2 the unproven amount of the al- his or her wages, salary, or other compensa- earlier.
lowance as excess reimbursement. This un- tion will be treated as a nonaccountable Report travel and entertainment ex-
proven amount is considered paid under a plan. This is because the employee is enti- penses on line 24 of Part II, Schedule C, or
nonaccountable plan (discussed later). tled to receive the full amount of his or her on line 2 of Schedule C–EZ.
compensation regardless of whether or not
Per diem or mileage allowance MORE he or she incurred any business expenses.
You must combine the amount of any re- Required records for client or customer.
than federal rate or standard mileage
imbursement or other expense allowance If you are a client or customer, you generally
rate. If your accountable plan pays a per
paid to your employees under a nonaccount- do not have to keep records to prove the re-
diem or other allowance that is higher than
able plan with their wages, salary, or other imbursements or allowances you give, in the
the federal per diem rate, or your mileage al-
lowance is higher than the standard mileage compensation. Report the total in box 1 of course of your business, to an independent
rate, employees do not have to return the dif- their Forms W–2. contractor for travel or gift expenses in-
ference between the two rates for the period curred on your behalf. However, you must
Example 1. You gave Kim $500 a month
or the miles they can prove business-related keep records if:
($6,000 total for the year) for her business
expenses. However, you must report this dif- expenses. You do not require Kim to provide 1) You reimburse the contractor for en-
ference between the rates as wages on their any proof of her expenses, and Kim can
Forms W–2. This excess amount is consid- tertainment expenses incurred on your
keep any funds that she does not spend.
ered paid under a nonaccountable plan (dis- behalf, and
You are reimbursing Kim under a nonac-
cussed later). countable plan. You include the $6,000 on 2) The contractor adequately accounts to
Kim’s Form W–2 as if it were wages.
Example. You send Maria on a 5-day you for these expenses.
business trip to Phoenix. She uses her per- Example 2. You pay Kevin $2,000 a
sonal car to make the trip and you reimburse month. On days that he travels away from
Contractor adequately accounts. If
the hotel directly. You give her a $200 ($40 home on business, you designate $50 a day
the contractor does adequately account to
× 5 days) advance to cover her meals and of his salary as paid to reimburse him for his
you for entertainment expenses, you (the cli-
incidental expenses and $192 (600 × 32 travel expenses. Because you would pay Ke-
cents) for the 600 business miles you expect vin his $2,000 monthly salary regardless of ent or customer) must keep records docu-
her to drive. The federal per diem rate for whether or not he was traveling away from menting each element of the expense. Use
meals and incidental expenses in Phoenix is home, the arrangement is a nonaccountable your records as proof for a deduction on your
$34. plan. You cannot treat any part of the $50 a tax return. If entertainment expenses are ac-
Maria’s trip only lasts 3 days and she day (that you designated as reimbursement) counted for separately, you are subject to
drives only 500 miles. She must return the as paid under an accountable plan. the 50% limit discussed earlier under En-
$80 ($40 × 2 days) advance for the 2 days tertainment Expenses. You do not, however,
she did not travel and the $32 (100 miles × Part of reimbursement paid under ac- have to file an information return to report
32 cents) for the 100 business miles she did countable plan. If you reimbursed ex- amounts for which you reimbursed the con-
not drive. For the days and miles Maria did penses under an otherwise accountable tractor, as long as he or she adequately ac-
travel, she can keep the $18 difference [($40 plan but an employee does not return, within counted to you for these expenses.
allowance she received – $34 federal rate a reasonable period of time, any reimburse- Contractor does not adequately ac-
for Phoenix) × 3 days] between the per ment for which the employee did not ade- count. If the contractor does not adequately
diem rates and the $10 difference [(32 quately account, that amount is considered account to you for allowances or reimburse-
cents-per-mile allowance she received – 30 paid under a nonaccountable plan. The re- ments of entertainment expenses, then you
cents-per-mile standard mileage rate) × 500 mainder is treated as having been paid (the client or customer) do not have to keep
miles] between the mileage rates. You must, under an accountable plan (as discussed your own separate records of these items in-
however, report $28 ($18 + $10) on her earlier). curred by the contractor on your behalf. You
Form W–2 as wages. are not subject to the 50% limit on entertain-
ment in this case. You can deduct the reim-
Contractors and Clients bursements or allowances as compensation
Nonaccountable Plans This section discusses special rules for inde- if they are ordinary and necessary business
A nonaccountable plan is a reimbursement pendent contractors and clients. expenses. However, you must file Form
or expense allowance arrangement that 1099–MISC, Miscellaneous Income, to re-
does not meet the three rules listed earlier Independent contractor. If you have reim- port amounts paid to the independent con-
under Accountable Plans. bursed travel, transportation, meal, en- tractor if the total of the reimbursements and
In addition, if you reimburse your employ- tertainment, or gift expenses that you in- any other fees is $600 or more during the
ees under an accountable plan, the following curred on behalf of a client, you should calendar year.
Page 80 Chapter 15 TRAVEL, ENTERTAINMENT, AND GIFT EXPENSES
4) Amounts allocated to former passive
Allocation of Interest activities.
16. The rules for deducting interest vary, de- 5) Amounts allocated to trade or business
pending on whether the loan proceeds are use and to expenses for certain low-in-
Interest used for business, home mortgage, invest- come housing projects.
ment, or passive activities. If you use the pro-
Expense ceeds of a loan for more than one expense, Partnerships and S corporations. Special
rules apply to the allocation of interest ex-
you must make an allocation to determine
the amount of interest for each use of the pense in connection with debt-financed ac-
loan’s proceeds. However, interest on a quisitions of, and distributions from, partner-
qualified home mortgage is fully deductible. ships and S corporations. These rules do not
Important Reminder For more information on home mortgage in- apply if the partnership or S corporation is
formed or used for the principal purpose of
for 1995 terest, see Publication 936.
The best way to allocate interest is to avoiding the interest allocation rules.
Refunds of interest shown on Form 1098. keep the proceeds of a particular loan sepa- Debt-financed acquisitions. This is the
Form 1098, Mortgage Interest Statement, rate from any other funds. You can treat an use of loan proceeds to purchase an interest
was revised in 1994. Box 3 of the form expenditure made from any account (or in in an entity or to make a contribution to the
shows any refunds for overpayment(s) of in- cash) within 30 days before or after the debt capital of the entity. If you purchase an inter-
terest you made in a prior year or years. See proceeds are deposited (or received in cash) est in an entity, allocate the loan proceeds
Mortgages, later in this chapter. as being from such debt proceeds. and the interest expense among all the as-
In general, the interest on a loan is allo- sets of the entity. The allocation can be
cated in the same way as the loan itself is al- based on the fair market value, book value,
located. This is true even if the funds are or adjusted basis of the assets, reduced by
Introduction paid directly to a third party. You allocate any debts allocated to the assets.
Interest is the amount you pay for the use of loans by tracing disbursements to specific If you contribute to the capital of an en-
borrowed money. You can generally deduct uses. If you must allocate your interest ex- tity, make the allocation based on the assets
all interest you pay or accrue during the tax pense, use the following categories: or by tracing the loan proceeds to the enti-
year on debts related to your trade or busi- ty’s expenditures. A purchase of an interest
For More
ness. (However, see Interest Capitalization, in an entity is treated as a contribution to
Expenditure Information
discussed later.) Special rules apply if you capital to the extent the entity receives any
Trade or business . . . . . . . . . . . . . . . . . . . . . See this proceeds of the purchases.
have a loan on which the interest rate is less
chapter
than the applicable federal rate. See Below- Example. You purchase an interest in a
Passive activity . . . . . . . . . . . . . . . . . . . . . . . . Publication
Market Interest Rate Loans, later. partnership for $20,000 using borrowed
925
To deduct the interest paid, you must be funds. The partnership’s only assets include
Investment (including portfolio) . . . . . . . Publication
liable for its payment. For example, you can- machinery used in its business valued at
550
not deduct interest paid on a corporation’s $60,000, and stocks valued at $15,000. You
debt on your individual return. allocate the loan proceeds based on the
Allocation based on use of loan’s pro- value of the assets. Therefore, $16,000 of
Topics ceeds. You allocate interest on a loan the the loan proceeds ($60,000 / $75,000 X
This chapter discusses: same way as the loan is allocated for the $20,000) and the interest expense on that
same period. Loan proceeds and the related part are allocated to trade or business use.
● Allocation of interest The amount allocated to investment use is
interest are allocated by the use of the pro-
● Interest you can deduct ceeds. The allocation is not affected by the $4,000 ($15,000 / $75,000 X $20,000) and
use of property that secures the loan. the interest on that part.
● Interest you cannot deduct
Example. You secure a loan with prop- Debt-financed distributions. Gener-
● Interest capitalization ally, if the entity borrows funds, the general
erty used in your business. You use the loan
● When to deduct interest proceeds to buy an automobile for personal allocation rules discussed earlier in this sec-
use. You must allocate interest expense on tion apply. If those funds are allocated to dis-
● Below-market interest rate loans
the loan to personal use (purchase of the au- tributions made to partners or shareholders,
tomobile) even though the loan is secured by the distributed loan proceeds and related in-
Useful Items terest expense must be reported to the part-
business property.
You may want to see: ners and shareholders separately. This is
Allocation period. The period a loan is
allocated to a particular use begins on the because the loan proceeds and the interest
Publication expense must be allocated depending on
date the proceeds are used and ends on the
□ 537 Installment Sales earlier of the date the loan is: how the partner or shareholder uses the pro-
ceeds. For example, if a shareholder uses
□ 538 Accounting Periods and Methods 1) Repaid, or distributed loan proceeds to invest in a pas-
□ 550 Investment Income and 2) Reallocated to another use. sive activity, that shareholder’s portion of the
Expenses entity’s interest expense on the loan pro-
Loan repayments. When any part of a loan ceeds is allocated to a passive activity use.
□ 551 Basis of Assets
allocated to more than one use is repaid, the For more information on interest alloca-
□ 936 Home Mortgage Interest loan is treated as being repaid in the follow- tion, see chapter 8 in Publication 535.
Deduction ing order:
1) Amounts allocated to personal use.
Form (and Instructions)
□ Sch A (Form 1040) Itemized
2) Amounts allocated to investments and Interest You Can
passive activities (other than those in-
Deductions
cluded in (3) below). Deduct
□ 1098 Mortgage Interest Statement 3) Amounts allocated to passive activities Generally, the amount agreed upon by the
□ 3115 Application for Change in in connection with a rental real estate lender and the borrower as interest can be
Accounting Method activity in which you actively participate. deducted when paid or accrued, unless it is
Chapter 16 INTEREST EXPENSE Page 81
required to be capitalized. Personal interest capital expenses that you add to the basis of If you buy property and pay interest owed
is not deductible. The intent of both parties your property. If the property mortgaged is by the seller (for example, by assuming the
must be to repay the loan. business or income-producing property, you debt and any interest accrued on the prop-
can amortize the costs over the life of the erty), you cannot deduct the interest. Add
Insurance contracts. If you borrow on your mortgage. the interest you paid that the seller owed to
life insurance, endowment, or annuity con- the basis of the property.
tract and use the proceeds for business pur- Partial liability. If you are liable for part of a
poses, you can take a business interest de- business debt, you can deduct only your Commitment fees or standby charges.
duction. (However, you cannot deduct the share of the total interest paid or accrued. Fees you incur to have business funds avail-
interest if you must capitalize it.) If you use able on a standby basis, but not for the ac-
Example. You and your brother borrow
the proceeds for a nonbusiness purpose, tual use of the funds, are not deductible as
money. You are liable for 50% of the note.
you cannot deduct the interest on Schedule interest payments. They may be deductible
You use your half of the loan in your busi-
A (Form 1040). Personal interest is not de- as business expenses.
ness, and you make one-half of the loan pay-
ductible. See Publication 17. If the funds are for inventory or certain
ments. You can deduct your half of the total
For loans on life insurance policies pur- property used in your business, the fees are
interest payments as a business deduction.
chased after June 20, 1986, no interest de- indirect costs and must be capitalized under
duction is allowed to the extent that total the uniform capitalization rules. See section
Partial payments on a nontax debt. If you 1.263A of the Income Tax Regulations on
loans on policies covering an officer, em-
make partial payments on a debt (other than uniform capitalization rules for more
ployee, or individual financially interested in
a debt owed IRS), the payments, in the ab- information.
your trade or business are more than
sence of any agreement between you and If you pay or incur commitment fees or
$50,000.
the lender, are applied first to interest and standby charges on a loan to have money
the remainder to principal. You can deduct made available when needed, you may be
Mortgages. Monthly mortgage payments
only the interest. able to deduct the expense. The commit-
are usually made up of principal and interest.
You can deduct only the interest, unless you ment fees are a cost of getting your loan and
Installment purchases. If you make an in- you can generally deduct part of the fees
must capitalize it. If you paid mortgage inter-
est of $600 or more during the year on any stallment purchase of business property, each year during the period of the loan. To
one mortgage to a mortgage holder (includ- you will pay interest either as part of each figure your deduction for each year, divide
ing a financial institution, a governmental payment or separately. If no interest or a low the part of the loan period falling within the
unit, or a cooperative housing corporation) in rate of interest is charged under the con- tax year by the total loan period. Then multi-
the course of that holder’s trade or business, tract, you may have to determine the un- ply this answer by the total amount of the
you will receive a Form 1098 or a similar stated interest amount. Generally, this may fees. If you do not take out a loan, you can
statement. happen if the seller finances your purchase. take a loss deduction for these fees in the
In addition, if you receive a refund of in- Unstated interest reduces your basis in the year your right to borrow the funds expires.
terest you overpaid in an earlier year, this property and increases your interest ex-
amount will be reported on box 3 of Form pense. For more information on installment Income tax owed. Interest paid or accrued
1098. You cannot deduct this amount. For sales and unstated interest, see Publication on income tax assessed on your individual
information on how to report this refund, see 537. income tax return is not a business deduc-
Refunds of interest, later in this chapter. tion even though the tax due is related to in-
Prepayment penalty. If you pay off your come from your trade or business. This inter-
est is treated as a business deduction only in
mortgage early and pay the lender a penalty
for doing this, you can deduct the penalty as
Interest You Cannot figuring a net operating loss deduction. See
interest. Deduct chapter 20.
Penalties. Penalties on deficiencies and
Points. The term ‘‘points’’ is often used
to describe some of the charges paid by a Some interest payments cannot be de- underestimated tax are not interest and can-
borrower when the borrower takes out a loan ducted. In addition, certain other expenses not be deducted. Fines and penalties are
or a mortgage. These charges are also that may seem to be interest are not, and are generally not deductible.
called loan origination fees, maximum not deductible as interest.
loan charges, or premium charges. If any of Interest related to tax-exempt income.
these charges is solely for the use of money, Payment by cash or equivalent. A cash Generally, interest related to tax-exempt in-
it is interest. method taxpayer cannot deduct interest un- come is not deductible. No deduction is al-
These points are interest paid in advance less it is paid in cash or its equivalent. If you lowed for:
and you cannot deduct it all in one tax year. are a cash method taxpayer, you cannot de- 1) Interest on a debt incurred to buy or
Instead, you can deduct part of the interest duct interest you pay with borrowed funds carry tax-exempt securities,
in each tax year during the period of the loan, you get from the original lender through a
unless it must be capitalized. second loan, an advance, or any other ar- 2) Amounts paid or incurred in connection
rangement similar to a loan. You may deduct with personal property used in a short
To figure how much to deduct in each tax
the interest expense once you start making sale, or
year, divide the part of the loan period falling
within your tax year by the total loan period. payments on the new loan. When you make 3) Amounts paid or incurred by others for
Then multiply this answer by the prepaid in- partial payments on loans, you first apply the the use of any collateral used in con-
terest. For example, if you take out a 10-year payment to interest and then to the principal. nection with a short sale.
loan on October 1, 1995, 3 months of the This rule does not apply if both you and the
loan period fall in your 1995 tax year. For lender intend for a different allocation to be If you deposit cash as collateral in a short
1995 you deduct 3/ 120 of the payments you made. All amounts you apply to the interest sale and the cash does not earn a material
made for the points. For 1996, you can de- on the first loan are deductible, along with return during the period of sale, item (2)
duct 12/ 120 of the prepaid interest. any interest you pay on the second loan, above does not apply. For more information
Expenses paid to obtain a mortgage. subject to any limits that apply. on short sales, see Publication 550.
Certain expenses you pay to obtain a mort-
gage cannot be deducted as interest. These Capitalized interest. There are certain in- Limit on investment interest. Your deduc-
expenses, which include mortgage commis- terest expenses you must capitalize rather tion for investment interest expense is lim-
sions, abstract fees, and recording fees, are than deduct. These are discussed later ited to the amount of your net investment in-
capital expenses. However, they are not under Interest Capitalization. come. This rule applies only if:
Page 82 Chapter 16 INTEREST EXPENSE
1) You are a noncorporate taxpayer (in- the level of the partnership or S corporation, Accrual method. You can deduct only in-
cluding shareholders and partners of S and then at the level of the partners or share- terest that has accrued during the tax year.
corporations and partnerships), and holders. These rules are applied to the ex- Prepaid interest. If you pay interest in
2) You paid or accrued interest on money tent the partnership or S corporation has in- advance, deduct it as it accrues over the pe-
you borrowed to buy or carry property sufficient debt to support the production or riod of the debt. This rule also applies to the
held for investment (including amounts construction expenses. amount subtracted on a discounted loan.
allowable as a deduction in connection If you are a shareholder in an S corpora- Payments unlikely to be made. If it is
with personal property used in a short tion, you may have to capitalize interest you unlikely that you will make the interest pay-
sale). incur during the tax year with respect to the ments because of your financial difficulty,
production costs of the S corporation. Simi- you can still take a deduction for accrued
For more information about the limit on larly, you may have to capitalize interest in- interest.
the investment interest expense deduction, curred by the S corporation with respect to Tax deficiency. If a corporation con-
see Publication 550. your own production costs. See Internal tests a federal income tax deficiency, inter-
Revenue Service Notice 88–99, 1988-2 C.B. est does not accrue until the tax year that fi-
422. You must provide the required informa- nal determination of liability is made. If the
Interest Capitalization tion in an attachment to the Schedule K–1 to corporation does not contest the deficiency,
properly capitalize interest for this purpose. then the interest accrues in the year the tax
Under the uniform capitalization rules, you
If you are a partner in a partnership, you was asserted and agreed to. Interest is de-
must generally capitalize interest on debt
may have to capitalize interest you incur dur- ducted in the year it accrues.
used to finance the production of real or tan-
gible personal property. The property must ing the tax year with respect to the produc- However, if a corporation contests but
tion costs of the partnership. Similarly, you pays the proposed tax deficiency and inter-
be produced by you for use in your trade or
may have to capitalize interest incurred by est and the corporation does not designate
business or produced by you for sale to cus-
the partnership with respect to your own pro- the payment as a cash bond, then the inter-
tomers. Interest on a debt on property that
duction costs. See Internal Revenue Service est is deductible in the year it is paid.
was acquired and held for resale does not
Notice 88–99. You must provide the required
have to be capitalized. Interest you paid or
information to properly capitalize interest for Related taxpayer. If you use an accrual
incurred during the production period must
this purpose in an attachment to the Sched- method, you cannot deduct interest owed to
be capitalized if the property produced is
designated property. Designated property ule K–1. a related person who uses the cash method
For more information on the uniform cap- until payment is made and the interest is in-
is:
italization rules, see section 1.263A of the In- cludible in the gross income of that person. If
1) Real property, come Tax Regulations and Internal Revenue a deduction is denied under this rule, the rule
2) Personal property with a class life of 20 Notice 88-99, 1988-2 C.B. 422, (as amended will apply even if your relationship with the
years or more, by announcement 89-72) available at most person ceases to exist before the interest is
3) Personal property with an estimated IRS offices. includible in the gross income of that person.
production period of more than 2 years, See the definition of related taxpayers in
or chapter 3.
4) Personal property with an estimated When To Deduct However, you can deduct the amount if
you pay it within 21/ 2 months after the end of
production period of more than one year
if the estimated cost of production is Interest your tax year and if the amount is paid:
more than $1 million. If interest capitalization (discussed earlier) For debt incurred on or before Septem-
does not apply to you, deduct interest as ber 29, 1983, or
Under this rule, you are considered to
follows. Under a contract that was binding on
have produced property if you construct,
build, install, manufacture, develop, improve, September 29, 1983, and thereafter
Cash method. You can deduct only pay-
create, raise, or grow the property. Property before the amount is paid or incurred.
ments of interest you actually made during
produced by you under a contract is treated the tax year. For instance, a promissory note
as produced by you to the extent that you you give covering interest owed is not de-
make payments or otherwise incur costs in ductible because it is a promise to pay and
connection with the property. not an actual payment. Below-Market Interest
Prepaid interest. Under the cash
Capitalized interest. Capitalized interest is
treated as a cost of the property produced. method, you generally cannot deduct any in- Rate Loans
You recover the interest when you sell or use terest paid before the year it is due. Interest A below-market loan is a loan on which no
the property, or dispose of it under the rules you pay that is properly allocable to a later interest is charged or on which interest is
that apply to such transactions. You recover tax year must be charged to a capital ac- charged at a rate below the applicable fed-
the capitalized interest through cost of count. Treat an advance payment as paid in eral rate. A below-market loan is generally
goods sold, an adjustment to basis, depreci- the period covered by the prepaid interest. treated as an arm’s-length transaction in
ation, amortization, or other method. Discounted loans. If interest or a dis- which you, the borrower, are treated as hav-
The capitalization rules of Internal Reve- count is subtracted from your loan proceeds, ing received:
nue Code sections 263A and 460 apply to in- it is not a payment of interest and you cannot
deduct it when you get the loan. A cash- 1) A loan in exchange for a note that re-
terest you pay or incur on any debt allocable quires the payment of interest at the ap-
to the costs of producing qualified property. method taxpayer must spread this discount
over the loan period and can deduct interest plicable federal rate, and
For example, these costs would include
planning and design activities that are gener- only when payments are made on the loan. 2) An additional payment.
ally incurred before the production period Refunds of interest. If you pay interest
begins, as well as the costs of raw land and and then receive a refund for any part of the The additional payment is treated as a gift,
materials acquired before the production pe- interest later in the same tax year, reduce dividend, contribution to capital, payment of
riod begins. Also, they include any costs you your interest deduction by the amount of the compensation, or other payment, depending
may incur under a contract for property pro- refund. If you receive the refund in a later tax on the purpose of the transaction. You may
duced by a third party. year, include the refund in income if the de- have to report this payment as additional in-
duction for the interest reduced your tax. In- come depending on its purpose.
Partnerships and S corporations. The in- clude in income only the amount of the inter- For more information, see chapter 8 in
terest capitalization rules are applied first at est deduction that reduced your tax. Publication 535.
Chapter 16 INTEREST EXPENSE Page 83
paid for its partners as guaranteed pay- or your partnership or S corporation paid the
ments made to the partners. premiums and you included these amounts
17. 5) An S corporation can deduct the cost of
in your gross income.
accident and health insurance premi- The deduction cannot be more than your
Insurance ums paid for its shareholders. net earnings from the trade or business in
which the medical insurance plan is estab-
6) Employers’ liability insurance. lished. Also, the deduction cannot be more
7) Malpractice insurance that covers your than your wages from an S corporation, if
professional personal liability for negli- this is the business in which the insurance
Important Change gence resulting in injury or damage to plan is established. Do not subtract the
amount of this deduction when figuring net
for 1995 patients or clients.
earnings for your self-employment tax. How-
8) Liability insurance that covers your lia- ever, subtract the amount of this deduction
Self-employed health insurance deduc-
bility for bodily injuries suffered by per- from your medical insurance when figuring
tion. The deduction for health insurance
sons who are not your employees and
costs for self-employed persons has been your medical expenses on Schedule A
for property damage to others.
permanently extended for tax years begin- (Form 1040) if you itemize your deductions.
ning after 1993. You may be able to file an 9) Workers’ compensation insurance set You cannot take the deduction for any
amended return (Form 1040X) to take the by state law that covers any claims for month if you were eligible to participate in
25% deduction for 1994. The deduction is bodily injuries or job-related diseases any subsidized health plan maintained by
increased to 30% for tax years beginning af- suffered by employees in your business, your employer or your spouse’s employer at
ter 1994. regardless of fault. A partnership can any time during the month. However, any
deduct workers’ compensation premi- medical insurance payments that are not de-
ums paid on behalf of partners as guar- ductible on line 26 of Form 1040 can be in-
anteed payments made to the partners.
Introduction An S corporation can deduct workers’
cluded as part of your medical expenses on
Schedule A (Form 1040) if you itemize your
You can generally deduct the ordinary and compensation premiums paid on behalf deductions. See chapter 10 in Publication
necessary cost of insurance for your trade, of shareholders.
535 for more information.
business, or profession as a business ex-
10) Contributions to a state unemployment
pense. However, you may have to capitalize
insurance fund. You can deduct these Note: The 25% deduction for medical in-
certain insurance costs under the uniform
contributions as taxes if they are con- surance costs for self-employed persons,
capitalization rules. For more information,
sidered taxes under state law. which had expired on December 31, 1993,
see Capitalizing Premiums, later.
11) Overhead insurance. This insurance has been extended retroactively from Janu-
Topics pays you for business overhead ex- ary 1, 1994, through December 31, 1994.
This chapter discusses: penses you have during long periods of You may need to file an amended return,
disability caused by your injury or Form 1040X, Amended U.S. Individual In-
● Deductible premiums come Tax Return, for 1994, to claim an addi-
sickness.
● Nondeductible premiums tional deduction for insurance costs paid
12) Car and other vehicle insurance. This
● Life insurance during 1994.
insurance covers liability, damages, and
However, you cannot take the deduction
● Capitalizing premiums other losses from accidents involving
for any month in 1994 if you were eligible to
● When to deduct premiums vehicles used in your business. If you
operate a vehicle partly for personal participate in any subsidized health plan
use, you can deduct only the part of maintained by your or your spouse’s em-
Useful Items your insurance premiums that applies to ployer at any time during that month. See
You may want to see: chapter 10 of Publication 535 for more infor-
the business use of the vehicle. If you
use the standard mileage rate to figure mation on refiguring your 1994 deduction.
Publication
your car expenses, you cannot deduct
□ 535 Business Expenses any car insurance premiums. See chap-
□ 538 Accounting Periods and Methods ter 15 for information on car expenses.
Nondeductible
Form (and Instructions)
□ 1040 U.S. Individual Income Self-Employed Health
Premiums
Tax Return You cannot deduct the following kinds of in-
Insurance Deduction surance premiums. For information on non-
You may be able to deduct 30% of the deductible life insurance premiums, see Life
amount paid during the tax year for medical Insurance, later.
Deductible Premiums insurance for yourself and your family. To
deduct this, you must: 1) Self-insurance reserve funds. You can-
You can generally deduct premiums you pay not deduct amounts credited to a re-
for the following kinds of insurance related to 1) Be self-employed, serve you set up for self-insurance. This
your trade or business. For information on
2) Be a general partner (or a limited part- applies even if you cannot get business
deductible life insurance premiums, see Life
ner receiving guaranteed payments) in a insurance coverage for certain business
Insurance, later.
partnership, or risks. However, your actual losses may
1) Fire, theft, flood, or similar insurance. be deductible.
3) Be a shareholder owning more than 2%
2) Credit insurance to cover losses from
of the outstanding stock of an S 2) Loss of earnings. You cannot deduct
unpaid debts.
corporation. premiums for a policy that pays for your
3) Group hospitalization and medical insur- lost earnings due to sickness or disabil-
ance costs paid for employees. If you qualify, take this deduction on line 26 ity. However, see the earlier discussion
4) A partnership can deduct the cost of ac- of Form 1040. You are allowed this deduc- on overhead insurance under Deducti-
cident and health insurance premiums tion whether you paid the premiums yourself ble Premiums.
Page 84 Chapter 17 INSURANCE
The $50,000 relates to insurance protec- Capitalization Rules in Publication 538 and
Life Insurance tion the employee receives during any part of
the tax year.
the regulations under Internal Revenue
Code section 263A.
The cost of group term insurance that
Generally, you can deduct premiums (cost of
you must include in your employees’ income
insurance) you pay or incur on life insurance
is not the actual cost of the excess cover-
policies covering the lives of your officers
age. Instead, it is the amount figured using
and employees if you are not the beneficiary
under the contract and can show that the
monthly costs listed in chapter 5 of Publica- When To Deduct
tion 535. Also, you may have to include in
premiums represent current pay. However,
certain key employees’ income the cost of Premiums
the total of the premiums paid combined with
the first $50,000 of this insurance. See chap-
other pay must be reasonable as discussed
ter 5 of Publication 535 for more information. You can usually deduct insurance premiums
in chapter 9.
If the insurance includes permanent ben- in the tax year to which they apply.
efits, you must include in the employee’s
Nondeductible premiums. You cannot de- income:
duct premiums on a life insurance policy cov- Cash method. If you use the cash method
ering yourself, an employee, or any person 1) The cost of the permanent benefits, of accounting, you must generally deduct in-
with a financial interest in your business if minus surance premiums in the tax year in which
you are directly or indirectly a beneficiary of you actually pay them, even if you incurred
the policy. This is true whether the policy in- 2) The amount paid by the employee for them in an earlier year.
sures you, your employee, or a person who the permanent benefits.
has a financial interest in your business. A
person has a financial interest in your busi- Permanent benefits are economic val- Accrual method. If you use an accrual
ness if the person is an owner or part owner ues provided under a life insurance policy method of accounting, you can generally de-
of the business or has lent money to the that extend beyond one policy year, such as duct insurance premiums in the tax year in
business. paid-up or cash surrender value. which you incur a liability for them, whether
For more information on group term life or not you pay them in the same year.
Where to deduct premiums. Deduct the insurance, see Group Term Life Insurance in
premiums on the ‘‘employee benefit pro- chapter 5 of Publication 535.
grams’’ line of the tax schedule or return for Cash or accrual method prepayments.
your business. You cannot deduct the entire premium for an
insurance policy that covers more than one
Partners. If, as a partner in a partnership,
Capitalizing Premiums tax year in the year you make the payment or
incur a liability for the payment. You can de-
you take out an insurance policy on your own Under the uniform capitalization rules, you duct only the part of the premium that ap-
life and name your partners as beneficiaries must capitalize your direct costs and a prop- plies to the current tax year. In each later tax
to induce them to retain their investments in erly allocable share of your indirect costs to year you can deduct the part that applies to
the partnership, you are considered a benefi- property produced or property acquired for that tax year.
ciary. You cannot deduct the insurance resale. ‘‘Capitalize’’ means ‘‘to include in in-
premiums. ventory costs’’ if the property is inventory Example. You operate a business and
and ‘‘to charge to a capital account or basis’’ file your returns on a calendar-year basis.
Security for loan. If you take out a policy on if the property is not inventory. You will re- You bought a fire insurance policy on your
your life or on the life of another person with cover these costs through depreciation, building effective October 1, 1995, and paid
a financial interest in your business to get or amortization, cost of goods sold, or by an ad- a premium of $1,200 for 2 years of coverage.
protect a business loan, you cannot deduct justment to basis at the time you use, sell, On your 1995 return, you can deduct only the
the premiums as business expenses. Nor place in service, or otherwise dispose of the part of the total premium that applies to the 3
can you deduct the premiums as interest on property.
months of coverage in 1995. The part of the
business loans or as an expense of financing You must use the uniform capitalization
premium that applies to 1996 and 1997 can
loans. In the event of death, the proceeds of rules if, in the course of your trade or busi-
be deducted in those years. Since the total
the policy are not taxed as income even if ness or an activity carried on for profit, you:
policy premium is $1,200 for 2 years, the
they are used to liquidate the debt. yearly rate is $600 and the monthly rate is
1) Produce real property or tangible per-
sonal property for use in the business or $50. For the 3-month period in 1995, you can
activity, deduct $150; for 1996, you can deduct $600;
Group term life insurance. You can gener-
and for the 9-month period in 1997, you can
ally deduct premiums you pay or incur for
group term life insurance covering the lives 2) Produce real property or tangible per- deduct $450.
of your officers and employees. However, sonal property for sale to customers, or If you use the cash method of accounting
you cannot deduct the premiums if you are and you do not pay the $1,200 premium until
directly or indirectly the beneficiary under the 3) Acquire property for resale. However, January 1996, you cannot deduct on your re-
contract. this rule does not apply to personal turn for 1995 the $150 for that year. How-
Cost taxable to employee. Generally, property if your average annual gross ever, you can deduct $750 (the $150 that ap-
you must include in an employee’s income receipts are not more than $10,000,000. plies to 1995 plus the $600 that applies to
the cost of group term life insurance cover- 1996) on your return for 1996.
age you provide on his or her life that ex-
Indirect costs include premiums for insur-
ceeds the total of:
ance on your plant or facility, machinery, Dividends received. If you receive divi-
equipment, materials, property produced, or
1) The cost of $50,000 of this insurance, dends from business insurance and you de-
property acquired for resale.
plus ducted the premiums in prior years, part of
the dividends are income. For more informa-
2) Any amount paid by the employee to- More information. For more information on tion, see Recovery of items previously de-
ward the purchase of the insurance. the uniform capitalization rules, see Uniform ducted in chapter 6.
Chapter 17 INSURANCE Page 85
□ Sch C (Form 1040) Profit or Loss Real estate sales. If real estate is sold, the
From Business deduction for real estate taxes must be di-
18. □ Sch C–EZ Net Profit From Business vided between the buyer and the seller ac-
cording to the number of days in the real
□ Sch SE (Form 1040) Self-
Taxes Employment Tax
property tax year (the period to which the
tax relates) that each owned the property.
□ 3115 Application for Change in The taxes are apportioned to the seller up to
Accounting Method but not including the date of sale, and to the
buyer beginning with the date of sale, re-
Introduction gardless of the accrual or lien dates under
local law. This information is usually included
You can deduct various taxes imposed by
federal, state (including certain Indian tribal
Real Estate Taxes on the settlement statement provided at
closing.
governments), local, and foreign govern- Deductible real estate taxes are any state,
If you (seller) cannot deduct taxes until
ments if you incur them in the ordinary local, or foreign taxes on real property levied
they are paid because you use the cash
course of your trade or business. Certain for the general public welfare. The taxes
method of accounting and the buyer of your
other taxes not attributable to your trade or must be based on the assessed value of the
property is personally liable for the tax, you
business are deductible only if you itemize real property and must be charged uniformly
against all property under the jurisdiction of are considered to have paid your part at the
deductions on Schedule A (Form 1040). time of the sale. This permits you to deduct
If you conduct business as a sole proprie- the taxing authority. Deductible real estate
taxes generally do not include assessments the part of the tax to the date of sale even
tor, deduct your business taxes on Schedule though you do not actually pay it.
C or C–EZ (Form 1040). A partnership de- for local benefits that increase the value of
the property. See Assessments, later. If you (the seller) use an accrual method
ducts its business taxes on Form 1065 and a
If you use the accrual method of account- and have not elected to ratably accrue real
corporation on Form 1120, Form 1120–A, or
ing, you generally cannot accrue real estate property taxes, the taxes apportioned to you
Form 1120S.
taxes until you pay them to the government (but not deductible for any year under your
Federal income, estate, and gift taxes
authority. You can, however, elect to ratably accounting method) accrue on the date you
and state inheritance, legacy, and succes-
accrue the taxes during the year. See Elec- sell the property.
sion taxes are not deductible.
If you use the cash method of account- tion to ratably accrue, later. Example. Al Green, a calendar year ac-
ing, your deduction for taxes can be taken crual method taxpayer, owns real property in
only in the year paid. If you use an accrual Assessments. Assessments for local bene- X County but has not elected to ratably ac-
method, your deduction can be taken only in fits that tend to increase the value of your crue property taxes. November 30 of each
the year the taxes are properly accrued. property (such as assessments for construc- year is the assessment and lien date. He
Uniform capitalization rules apply to cer- tion of streets, sidewalks, and water and sold the property on June 30, 1995, and
tain taxpayers who produce real or tangible sewerage systems, or to provide public park- under his accounting method would not be
personal property for use in a trade or busi- ing facilities) generally are not deductible. If able to claim a deduction for the taxes be-
ness, or for sale to customers, or acquire the local benefit increases the value of your cause the sale occurred before November
property for resale. Under these rules, cer- property, you must capitalize the 30. The part of the 1995 tax apportioned to
tain expenses that are allocable to the prop- assessment. him, 180/365 (January 1–June 29), is
erty, including taxes, may have to be in- Local assessments for maintenance, re- treated as having accrued on June 30, and is
cluded in inventory costs or capitalized. In pairs, or interest charges for benefits such deductible for 1995.
some cases, you may elect to capitalize as streets, sidewalks, and water and sewer- Excess deduction. If you sold real prop-
taxes. For more information, see Uniform age systems are deductible. If only part of erty, the deduction you claimed last year for
Capitalization Rules in chapter 7. the assessment is for maintenance, repairs, real property taxes may be greater than the
or interest, you must be able to show the taxes apportioned to you, as already dis-
Deductible taxes. Taxes that are deducti- amount allocated to the different purposes. cussed. If this occurs, the excess is included
ble are broken down into broad categories: If you cannot show what part of the assess- in your gross income to the extent provided
ment is for maintenance, repairs, or interest, in Recovery of items previously deducted in
1) Real estate taxes;
none of it is deductible. chapter 6.
2) State and local income taxes;
Example. City X, to improve downtown
3) Employment taxes (see chapter 33); commercial business, converted a down- Election to ratably accrue. An accrual
and town business area street already improved method taxpayer may elect to accrue ratably
by lights, sidewalks, sewers, etc., into an en- real property taxes that are related to a defi-
4) Other taxes.
closed pedestrian mall. The full cost of con- nite period of time over that period of time.
struction, financed with 10-year bonds, was Example. John Smith is a calendar year
Topics assessed against the affected properties. taxpayer who is on an accrual method. His
This chapter discusses: The property owners have to make pay- real property taxes that apply to the fiscal
ments of principal and interest annually for year July 1, 1995, to June 30, 1996, amount
● Real estate taxes 10 years, which is also the period of ex- to $1,200. The assessment and lien date is
● State and local income taxes pected business advantage. July 1.
● Other taxes The assessments incurred by the prop- If for 1995 John makes the election to
erty owners are not deductible as taxes, or ratably accrue the taxes, $600 of the taxes
as business expenses, but are depreciable will accrue in 1995 and the balance will ac-
Useful Items
capital expenses. The part of the payments crue in 1996.
You may want to see:
that is to pay the interest charges on the Separate elections. An election may be
Publication bonds is deductible as taxes. made for each separate trade or business
and for nonbusiness activities if accounted
□ 378 Fuel Tax Credits and Refunds Charges for services. Water bills, sewer- for separately.
age, and other service charges assessed The election to ratably accrue real prop-
Form (and Instructions) against your business property are not real erty taxes is binding unless you get permis-
□ Sch A (Form 1040) Itemized estate taxes, but are deductible as business sion from the IRS to change the method of
Deductions expenses. deducting real property taxes.
Page 86 Chapter 18 TAXES
Any real property taxes that are normally Accrual of additional unpaid state in- Do not deduct state and local sales taxes
deductible for the tax year, and that apply to come taxes. If an accrual method of ac- imposed on the buyer that you were required
periods prior to the year of the election, are counting is used and liability is contested, to collect and pay over to the state or local
deductible for the tax year in which you make any increase in deductible business taxes for government. These taxes are not included in
the election. a previous year will accrue and be deductible gross receipts or sales.
Making the election. If you make your in the year the amount is finally determined.
election for the first year in which real prop- Filing a state tax return is not considered Self-employment tax deduction. You can
erty taxes are incurred, attach a statement to contesting a liability for additional state in- deduct half of your self-employment tax
your income tax return for that year. File the come taxes assessed against taxpayers for when figuring your adjusted gross income.
return by the regular due date (including ex- prior years. Without some objective act of This is an income tax adjustment only. It
tensions). The statement should indicate: protest or evidence of denial of liability by an does not affect your net earnings from self-
accrual method taxpayer, any additional employment or your self-employment tax.
1) The trades or businesses to which the state taxes assessed for a prior year is de- To deduct the tax, enter on Form 1040,
election applies, and the accounting ductible for the prior year rather than in the line 25, the amount shown on the ‘‘Deduc-
method or methods used; year the amount is finally determined. tion for one-half of self-employment tax’’ line
However, a taxpayer who uses a consis- of the Schedule SE.
tent method of accounting to deduct addi-
2) The period of time to which the taxes re-
tional prior year state taxes (including uncon- Fuel taxes. Taxes on gasoline, diesel fuel,
late; and
tested ones) in the year they are finally and other motor fuels that are used in your
determined may continue to use that ac- business are deductible. They usually are in-
3) The computation of the real property tax counting method and deduct the additional cluded as part of the cost of the fuel itself
deduction for the first year of election. taxes in the year finally determined. If that and are not deducted as a separate item.
taxpayer deducts the additional taxes Also, you may be entitled to a credit or re-
against income of the prior year, a credit or fund for federal excise tax paid on fuels used
If you make an election for a year that is
refund will be allowed only if the taxpayer re- for certain purposes. For more information,
not the first year the real property taxes are
ceived permission from the IRS to change see Publication 378.
incurred, file Form 3115, Application for
the accounting method.
Change in Accounting Method. Generally,
Unemployment fund taxes. As an em-
this form should be filed within 180 days from
ployer, you may have to make payments to a
the beginning of the tax year for which the
state unemployment compensation fund or
election is to be effective, and you may have
to pay a user fee. See the instructions for
Other Taxes to a state disability benefit fund. These pay-
The following are other taxes that you can ments are deductible as taxes.
Form 3115 for more information.
Changing the election. To change an deduct if they are incurred in the ordinary
course of your trade or business. Franchise taxes. Corporate franchise taxes
election to ratably accrue real property
are deductible as a business expense. If you
taxes, file Form 3115, as discussed above.
Personal property tax. You can deduct are a cash-basis taxpayer, you deduct the
any tax imposed by a state or local govern- franchise tax in the year paid. If you are an
Limitation on accrual of taxes. A taxing ju- ment on personal property used in your trade accrual-basis taxpayer, you take a deduction
risdiction can require the use of an earlier or business. in the year you become legally liable to pay
date for accruing taxes than that which was the tax regardless of the year the tax is
previously required. However, the accrual Sales tax. Sales tax you pay on a service or based on. For example, if your state imposes
date for federal income tax purposes is the on the purchase or use of property is treated a franchise tax for 1995 that is based on your
date on which the tax would have accrued as part of the cost of service or property. If corporate net income for 1994, you deduct
had no action been taken. the service or the cost or use of the property the tax in 1995 if you are on an accrual basis
is a deductible business expense, you can because that is the year you became legally
deduct the tax as part of that service or cost. liable for the tax.
If the property purchased is merchandise for
resale, the sales tax is part of the cost of the Excise taxes. All excise taxes you pay or in-
State and Local merchandise. If the property is depreciable, cur as ordinary and necessary expenses of
the sales tax is added to the basis for depre- carrying on your trade or business can be de-
Income Taxes ciation. Get Publication 551 for information ducted as operating expenses.
on the basis of property.
State income taxes imposed on a corpora-
tion or partnership are deductible by the cor-
poration or partnership. However, state in-
come taxes imposed on an individual are not
deductible by the individual as business ex-
penses, but are deductible as an itemized
deduction on Schedule A (Form 1040).
A state tax on gross income (as distin-
guished from net income) directly attributa-
ble to a trade or business carried on by an in-
dividual or a partnership is deductible as a
business expense.
Chapter 18 TAXES Page 87
Topics Black lung benefit trust contributions. If
This chapter discusses: you, as a coal mine operator, make a contri-
19. ● Bribes and kickbacks
bution to a qualified black lung benefit trust,
you may be able to deduct it. To be deducti-
Other Business ● Lobbying expenses ble, you must make your contribution during
the tax year or pay it to the trust by the due
● Loss recovery
Expenses ● Penalties and fines
date for filing your federal income tax return
(including extensions). You must make the
contribution in cash or in property the trust is
● Repayments permitted to hold.
● Other miscellaneous expenses Figure your allowable deduction for con-
Important Change for tributions to a black lung benefit trust on
Schedule A of Form 6069.
Useful Items
1995 You may want to see:
Bribes and kickbacks. You cannot deduct
Club dues. Generally, you are not allowed
bribes, kickbacks, or similar payments if they
any deduction for dues paid or incurred for Publication
are either of the following:
membership in any club organized for busi-
□ 529 Miscellaneous Deductions
ness, pleasure, recreation, or other social 1) Payments directly or indirectly to an offi-
purpose. However, you may be able to de- □ 587 Business Use of Your Home cial or employee of any government or
duct dues paid to chambers of commerce (Including Use by Day-Care Providers) an agency or instrumentality of any gov-
and to professional societies. See Dues and ernment in violation of the law. If the
□ 946 How To Depreciate Property
subscriptions. government is a foreign government,
the payments are not deductible if they
Form (and Instructions) are unlawful under the Foreign Corrupt
□ Sch A (Form 1040) Itemized Practices Act of 1977.
Important Reminders Deductions 2) Payments directly or indirectly to a per-
for 1995 □ 1099-MISC Miscellaneous Income son in violation of any federal or state